The Republicans’ new tax manifesto sure looks like the break that big business has been waiting for. But though CEOs are guardedly optimistic about what they’re hearing from President Trump and the GOP leadership, they’re also wary that when the specifics of how the new regime really works are released, the proposal may offer little or nothing to lighten what they regard as a giant handicap crimping their competitiveness on world markets.
The C-suite worries are justified. The outline is so replete with non-specifics, vague language, and hints at measures that could mean far higher levies than the GOP appears to be advertising, let alone what Congress enacts, that its true impact remains disturbingly hard to grasp.
The headlines look good. The framework unveiled on Sept. 27 by the White House and Republican leaders in Congress promises the two principal reforms that businesses have craved above all others. The first is a big reduction in the statutory corporate tax rate, now the highest in the industrialized world. That levy would drop sharply, from 35% today to 20%, putting it below the 22.5% average for the OECD. The second long-sought prize is transitioning to a “territorial” system for taxing foreign profits, a shift that would theoretically eliminate the excessive burden borne by U.S. multinationals versus their overseas rivals.
The platform also promises a third major boon to businesses—immediate, 100% expensing of capital investments. Today, companies typically expense capex over five to 15 years. The new plan would allow them to write off all of those investments, except spending on “structures” such as plants and warehouses, in the year the investments are made, greatly reducing their near-term tax bills. “It’s part of the campaign to bring manufacturing jobs back to America,” says Bernadette Pinamont, chief tax officer at Vertex, a firm that provides tax services and technology to businesses. “The immediate expensing is designed to entice companies to produce new product lines in the U.S. rather than abroad, to make investment in equipment used to manufacture here in the U.S. more favorable.”
Though the plan’s broad targets should please America’s multinationals, the actual influence on what matters most—their total worldwide tax bill and their competitiveness on global markets—remains murky. “Companies are busy modeling the outcomes right now,” says Pinamont. “But they won’t get a clear picture until they see the mechanics of how these proposals work in practice.”
In fact, businesses are pondering three burning questions at the heart of the new proposals. All three relate to the most difficult issue the U.S. faces in moving to a territorial tax system, a shift sought by both Republicans and Democrats. The danger is that multinationals will move production to offshore tax havens en masse, severely eroding America’s corporate tax base, shrinking future revenues, and deepening deficits already on a perilous trajectory.
The first big question involves the proposed “minimum tax” on foreign earnings. CEO’s doubtless groaned when they saw that mandate in the new framework. How will the minimum tax work, and how big will it be? Second, the plan uses coded language that could auger a second, special tax on products based on intellectual property that are made in low-cost nations—tech and pharma, beware! Third, the platform looks to pay for tax cuts by restricting the expensing of interest on corporate debt. How much will the final rules curb what’s long been one of the corporate America’s biggest tax breaks?
1. Will the minimum tax on foreign earnings help, or hurt?
The tax proposal states that the new territorial regime “would replace the existing, outdated worldwide tax system with a 100% exemption on dividends from foreign subsidiaries.” Under today’s “worldwide system,” U.S.-based companies face our 35% statutory rate on all profits, generated anywhere in the world. (They receive a credit for levies paid in the local country, and owe the Treasury the difference between that local rate and America’s 35%.)
Moving the U.S rate to 20% would make U.S. companies a lot more profitable, just from the savings on their U.S. tax bills alone. But the biggest lever for raising our competitiveness is overhauling the treatment of profits generated abroad. Almost all industrialized nations are governed by territorial systems requiring their multinationals to pay local taxes only in the foreign nations where they operate. Multinationals have long argued that because their foreign as well as domestic profits are taxed in the U.S. at one of the world’s highest rates, they’re handicapped by far fatter tax bills on overseas production than their foreign competitors, notably the Europeans.
But U.S. multinationals have also long benefited from a giant loophole. As long as they leave foreign profits in the host country, the U.S. tax bill remains at zero—until the profits come home. Hence, multinationals regularly invest those deferred earnings in plants and labs offshore, and pay no U.S. tax on foreign earnings for decades, if ever. Today, an estimated $2.6 trillion in untaxed earnings remain sitting in foreign subsidiaries.
The new proposal would eliminate the loophole. The idea is that if U.S. multinationals owe tax only in the host country, they would have no incentive to leave earnings there to avoid taxes. So they’d lose nothing by sending the funds home, where they could flow into everything from new auto plants to share buybacks to acquisitions. The framework would require companies to immediately “repatriate” all profits parked in foreign subsidiaries. Although those deferred earnings would be taxable when the measure is enacted, companies would have “several years” to make the payments. They’d also benefit from a lower rate on profits invested in such illiquid assets as plants and labs than the full levy on those parked in cash and securities. The tax rate has yet to be determined. But in the past, both parties have advocated imposing a low, flat, single-digit duty on repatriated profits. If the repatriation proposal becomes law, it would generate a windfall to the Treasury of hundreds of millions of dollars, funds that Congressional leaders have advocated channeling to upgrade America’s crumbling infrastructure.
On the big points, the proposal looks like a major win for multinationals. Losing the ability to defer U.S. taxes indefinitely is really losing nothing if a multinational is only paying the local levies. But read on. That won’t necessarily be the case. The next-to-last sentence in the nine-page framework states the following: “To prevent companies from shifting profits to tax havens, the framework includes rules to protect the U.S. tax base by taxing at a reduced rate and on a global basis foreign profits of U.S. multinational corporations.”
In other words, U.S. companies would not be simply paying, say, the 12.5% rate in Ireland on profits booked there. They’d potentially be subject to a “minimum tax” on foreign profits. The proposal does specify a “reduced” rate, strongly implying the number would be below the 20% U.S. statutory levy.
So the minimum rate is a mystery. We do know that the plan leaves open a levy below 20%. So something around 18% would seem highly possible. Indeed, a proposal in the final Obama budget for 2016 advocated a formula that could have pushed the minimum over 20%.
How the minimum would be imposed is another mystery. Here are the possibilities. First, the Treasury might use a “cumulative” approach by adding together all a company’s offshore profits. If the minimum tax is 18%, and the company paid less by sheltering profits in lots of tax havens, it would pay the difference in U.S. taxes. Second, the Treasury might go country to country. If a drugmaker is paying 12.5% in Ireland, and 9% in Hungary, it would need to pay the difference in the U.S, amounting to an extra 5.5% for Ireland, and 9% for Hungary.
The choice is critically important. Here’s why. Say a multinational books 35% of its $1 billion in foreign profits in Ireland and Hungary at an average local rate of 10%, and the other 65% in other countries at the world average of 22.5%. If the minimum tax is assessed cumulatively, the company would owe nothing; the requirement is $180 million (18% of $1 billion), and it’s paying $35 million in Ireland and Hungary, and $146 million in other foreign nations, for a total of $181 million, $1 million over the floor.
But if the U.S. goes country by country, the multinational wouldn’t get credit for paying more than the minimum tax on 65% of its earnings. Instead, it would be hit with a surcharge of 5.5% in Ireland (to bring the total to 18%), and 8% in Hungary. It would owe an additional $28 million, raising its total foreign tax bill to almost 21%.
Calculated either way, the minimum tax means that U.S. companies would pay more overall than foreign competitors with the same foreign footprint. “Going country by country would be extremely hard on multinationals with lots of operations in extremely low tax nations,” says Kyle Pomerleau of the conservative-leaning Tax Foundation.
The minimum tax is especially troublesome for tech and pharma companies that have large operations in such low-tax nations as Ireland. “It’s even possible that a company could be worse off than before,” says Pomerleau. He notes that many companies now pay no U.S. tax on foreign profits because of the deferral loophole, yet generate lots of earnings from investments in those nations that they. in turn, keep reinvesting abroad tax-free. The reform proposal kills all deferrals. If a company faces an 18% minimum tax in Ireland, it can no longer simply pay the Irish tax only, leave the profits in the foreign sub, and delay paying the 5.5% difference for decades. It would need to cover that difference immediately, no loopholes allowed. “In the past, the company could delay paying for many decades, so the present value of the tax liability would be well below 5.5%,” says Pomerleau. So for companies with heavy production in tax havens such as Ireland, tax bills could actually rise.
For many multinationals, the proposed reforms would appear to lower their overall taxes on foreign earnings. That’s a good thing. The problem is that the benefits are unlikely to be as rich as advertised—again, because of the minimum tax. A pharma company in Ireland could pay 18% on its earnings there, while a Swiss competitor would owe just 12.5%, putting our drugmaker at a severe disadvantage.
For the U.S. economy, the minimum tax has an additional drawback. In recent years, many companies have “inverted” by moving headquarters from the U.S. to other nations as a strategy to escape our worldwide taxation. The lure of inverting would remain as a way to escape the minimum tax. As law firm Baker Hostetler stated in a study of the new plan, “The proposal to continue to tax U.S.-based companies on their worldwide income (albeit at a lower rate and with a stated purpose targeting tax haven activity) is problematic and could lead to continued pressure on U.S.-based companies not to be headquartered in this country.”
2. Will the plan hit intellectual property?
The proposal saves the potentially worst for last. In the very last sentence on page 9, following the one introducing the concept of a minimum tax, the framework uses extremely vague language that for experts, sounds ominous. It reads, “The committees will incorporate rules to level the playing field between U.S. headquartered parent companies and foreign-headquartered parent companies.” For Pomerleau, those may be code words for a special levy—on intellectual property.
In moving to a territorial system, the U.S. could risk handing companies an incentive to shift highly mobile assets to tax havens, causing what’s called “stripping the tax base” at home. And nothing is more immediately moveable than patents, licenses and the like. The GOP plan strongly implies that it will take strong measures to prevent that erosion. Pomerleau and other experts reckon that, to protect the U.S. tax base, the GOP framework may contain a final proposal similar to the one contained in a blueprint from 2014 that’s still regarded as a template by legislators of both parties. In that plan, then-Congressman Dave Camp championed imposing a special tax on what’s called “round-tripping.” The idea was to remove all incentives for putting IP in a tax haven instead of the U.S.
Here’s a summary of the Camp solution: Say a pharma company is generating lots of profits on patents in Ireland, and selling the drugs in the U.S. The Camp plan would have imposed the regular U.S. tax rate on those profits from Ireland. So the drugmaker would pay the same levies by producing at home. The tax advantage of manufacturing in Ireland would vanish. But the plan contained a carrot as well as a stick. On products using IP produced either in the U.S. or anywhere else in the world, and sold outside the U.S., the company would pay a preferential rate far lower than the regular U.S. rate. (Camp was advocating a U.S. rate of 25%, and a preferential rate of 15%.)
“The danger is that they will bring back the Camp approach,” says Pomerleau. “This is an influential idea that’s floating around.” In that case, products using IT that are made in tax havens and sold in the U.S., everything from drugs to software, could be subject to the proposed U.S. rate of 20%. That number could be even higher than the overall minimum tax on foreign profits. So a U.S. producer making patented drugs in Ireland for sale in the U.S. would pay 20%, while a German or Swiss competitor making similar products for sale in America would pay just 12.5%, or 7.5% less.
3. How much of their interest deduction will companies lose?
The plan states that interest payments on debt “will be partially limited.” That policy echoes the House proposal that advocated barring all interest deductions on new borrowings, but not on debt already on the books. The best bet is that the GOP proposal would also apply only to fresh debt. “If it applied to existing debt, companies would argue that they’d been unfairly penalized because the rules were totally different when they took out the loans or sold the bonds,” says Pomerleau.
The purpose of restricting the interest deduction appears two-fold. First, it’s a base-broadener that swells taxable earnings, and hence pays for part of the revenue lost by lowering the corporate rate by 15 points to 20%. Second, the cap would discourage corporations from doing what the plan appears to fear most, stripping the U.S. corporate tax base. If companies are getting a big break on income generated in Ireland, say, they’d have an incentive to make big loans from their Irish subsidiary to the parent in the U.S. The reason: The interest expense would cut taxable income at home, where rates would still be a lot higher than in Ireland. And the interest paid to the Irish sub would be taxed at a bargain rate. So the Treasury’s take in the U.S. would shrink, in a textbook case of stripping the base.
As so often the case in the new outline, no specifics are offered on how much interest would remain deductible. But given the need for revenue-raisers, it’s likely that the Republicans will start by advocating severe limits on expensing interest. Look for the real estate industry to battle the provision, or demand special favors.
These warnings don’t mean that if enacted, the new tax-reform plan won’t greatly benefit U.S. industry. But the questions it raises suggest that those benefits could be a lot more modest than the competitiveness-enhancing breakthroughs the plan is promising. And it could leave many losers, especially in tech and pharma. So far, the plan is skeletal, and the bones look good. How the GOP puts flesh on those bones––and the most important details relate to foreign profits––will determine whether tax reform is a true revolution, or just a modest step forward.