The Tax Cuts and Jobs Act (TCJA), signed into law by President Trump on December 22nd, 2017, enacted several significant reforms to the Federal Income Tax Code affecting corporate entities. Part One of my blog series focused on the tax rate reduction. This post focuses on another important change: the U.S. shift from a worldwide corporate tax system to a territorial tax system.
This change means that U.S.-based multinational corporations now pay income taxes only against U.S. earnings—as opposed to a corporate tax on worldwide earnings.
How does this policy change impact U.S. competitiveness?
Taxing global corporations only on earnings within U.S. borders makes the country more competitive with other developed nations. An overwhelming majority of the developed world has favored a territorial approach similar to that enacted by the TCJA.
The previous worldwide approach levied income tax on a company’s worldwide corporate earnings. When income was earned in low-tax countries such as Ireland which has a 12.5% rate, U.S.-based multinationals would pay an additional 22.5% rate (after foreign income tax credits, under the former 35% rate) in order to repatriate their foreign earnings. This created a significant cost disadvantage for U.S.-based multinationals compared to their foreign counterparts who would only pay the original 12.5%.
Will fixing the U.S. tax disparity bring investment back home?
Prior to the TCJA, many U.S. multinational companies would defer foreign earnings to avoid paying taxes at the highest rates. U.S.-based multinationals also frequently implemented a tax strategy called a “corporate inversion,” whereby the multinational’s parent company would be domiciled outside of the U.S. to avoid the worldwide tax system.
A 2013 report from the Congressional Budget Office titled “Options for Taxing U.S. Multinational Corporations,” summarized the effect: “The current tax system provides incentives for U.S. firms to locate their production facilities in countries with low taxes to reduce their tax liability at home. Those responses to the tax system reduce economic efficiency because the firms are not allocating resources to their most productive use … Such profit shifting erodes the corporate tax base and leads to wasted resources for tax planning.”
While this inversion strategy was temporarily halted by the Obama Administration, tax avoidance strategies still remained prevalent since the worldwide system resulted in capital being allocated outside the U.S.
Could gains from the new tax bill be diminished?
The switch to the territorial tax system makes the U.S. more competitive, but another provision of the TCJA called the Base Erosion and Anti-Abuse Tax (BEAT) could diminish its gains.
BEAT applies a 10 percent minimum tax for taxable income adjusted for base erosion payments (base erosion is a global tax avoidance strategy where companies shift profits to low-tax countries). The tax only affects businesses where U.S. gross receipts are more than $500 million.
This is an anti-abuse tax rule common in territorial systems to prevent tax avoidance. France, Germany, and Italy, for example, do not allow foreign earnings to be exempted from their territorial systems if the earnings are “realized” in countries with significantly lower tax rates from their own.
On balance, the TCJA’s changes to the U.S. treatment of foreign income make the country more competitive for attracting both domestic and foreign investment.
Stay tuned: Part Three of this four-part series analyzes the changes of the federal corporate income tax treatment of deferred foreign earnings.