American multinational enterprises (“MNEs”) like Apple, Microsoft, Oracle, and Citigroup have leveraged the existing U.S. international tax system to amass an estimated $2.6 trillion in undistributed, non-previously-taxed foreign earnings, according to an estimate prepared by the Joint Committee of Taxation during 2016. To give scale to that massive number, $2.6 trillion is nearly 13% of the S&P 500 Index’s market cap and greater than the GDPs of all but the five largest national economies.
While on the campaign trail, President Trump’s pro-growth tax plan consistently included some variation on a “10% tax on repatriation,” which he promised would “instantly [bring] trillions of dollars back into the U.S. economy [that are] now parked overseas.” Such a “tax holiday” (if voluntary) or “deemed repatriation” (if compulsory) would provide an enormous windfall to U.S.-based MNEs, unleashing cash trapped in foreign subsidiaries to finance dividend distributions, stock repurchases, and acquisitions at a rate far below the federal government’s 35% corporate income tax rate. While critics have attempted to trivialize the benefits of a tax holiday, downplaying the odds that MNEs will direct the cash to create jobs in line with President Trump’s stated policy goal, proponents have deftly pointed to the broader economic benefits inherent in giving investors (whether the MNEs that repatriate the cash or the various beneficiaries of their subsequent cash disbursements) more opportunity to invest and spend across the U.S. economy as a whole.
Why do we need a tax holiday?
The United States has a “worldwide system” of international taxation, which means that domestic MNEs are taxed on both domestic income and foreign income that they earn directly or through foreign branch operations.
How, then, have MNEs managed to keep so much of their taxable income out of the IRS’s reach? Quite easily, it turns out. The “active” income (i.e., income earned through the sale of goods or provision of services) of foreign corporate subsidiaries is generally not taxed in the United States until it is distributed to the U.S.-chartered parent. That is, taxation is “deferred” until income is voluntarily repatriated or recaptured through the complex subpart F regime (which denies deferral for certain passive and highly mobile income). Upon repatriation, MNEs can claim a foreign tax credit (“FTC”) for a portion of income taxes paid to foreign taxing authorities. While the FTC allowance mitigates the double taxation levied under a worldwide system, MNEs are still on the hook for a lot more tax than they would have paid had they continued to retain or reinvest their income in, let’s say, Ireland. The table below provides a snapshot of the United States’ high corporate tax rate relative to those of common “tax havens.”
Table 1: Comparison of Select National Corporate Tax Rates (2017)
|Country||Corporate Tax Rate
|Country||Corporate Tax Rate
|United States||35||United States||35|
|Bahamas||0||Isle of Man||0|
|Bermuda||0||Jersey||0/10/20 (rate varies)|
|British Virgin Islands||0||Luxembourg||19|
Source: Deloitte (March 2017)
Unsurprisingly, this polarizing tax ecosystem (i.e., a worldwide system that allows for deferral, coupled with the drastic income tax rate differential between the United States and low-tax or no-tax countries) incentivizes American MNEs with sufficient access to capital to minimize the offshore earnings that they repatriate to the United States. In brief, U.S. international tax law encourages deferral of foreign earnings. And that is, very roughly, why $2.6 trillion (and counting) is indefinitely deferred beyond our borders with little hope of filtering into the Treasury Department’s coffer.
Unless we alter the incentives, that is. And that is exactly what a tax holiday would do, by offering companies a one-time shot to unlock foreign income at a tempting 10% rate that accounts for the competitive realities presented in Table 1.
President Trump once claimed that he might eliminate deferral entirely, breaking from the typical Republican position advocating movement to a territorial system that exempts foreign income from U.S. taxation. Compared to our worldwide system, a territorial system would make American MNEs more competitive with foreign businesses. Exempting foreign income is supported by the principle of capital import neutrality, which holds that firms with different nationalities that invest in a given country should be subject to the same tax rates. On the other hand, eliminating deferral would make American MNEs less competitive than they are today because foreign income (which can be indefinitely deferred under our current system) would be subject to U.S. taxation. Are there any arguments for eliminating deferral? Of course. The principle of capital export neutrality, which states that firms should face the same tax burden whether they invest abroad or at home, supports current taxation of foreign earnings. More practically, eliminating deferral would remove the tax incentive to leave foreign earnings abroad. A tax holiday (or deemed repatriation), which would tax past foreign earnings at a lower rate, can be seen as a compromise between the competing principles of capital import neutrality and capital export neutrality.
To be sure, tax holidays raise a number of unsettled technical questions that the Trump administration must first address. For example, should foreign taxes paid on foreign earnings be fully creditable? Or should the credit be “haircut” to reflect the trimmed 10% tax rate?
What impact would it have?
Based on President Trump’s comments to date and on past U.S. tax holidays (the last of which was held in 2004), it is estimated that about 40% of untaxed foreign earnings (i.e., over $1 trillion) would ultimately return to the United States, netting more than $100 billion in tax revenue and invigorating MNEs with billions in after-tax income. Table 2, produced by the Institute on Taxation and Economic Policy (“ITEP”), presents the ten MNEs with the largest stockpiles of untaxed foreign earnings, and thus, the ten MNEs most likely to benefit “bigly” from a 10% deemed repatriation.
Table 2: MNEs With Largest Projected Tax Savings from a 10% Deemed Repatriation
|Taxes Due on Offshore Profits
|Savings From 10% Deemed Repatriation
|J.P. Morgan Chase & Co.||34.6||8.2||5.9|
|Goldman Sachs Group||28.6||5.7||4.0|
|Bank of America||18.0||5.0||3.6|
Source: ITEP (January 2017)
It is expected that technology and healthcare MNEs, which alone held $1.14 trillion in untaxed foreign earnings at year-end 2015, would benefit most from a tax holiday. In an ideal world, we might envision these companies investing their cash windfall in R&D, new plants, and new jobs. Realistically, however, as demonstrated by their ability to maintain income offshore in the first place, these companies probably have plenty of capital to fund organic growth-oriented investments. But is it really such a bad thing if MNEs put their discretionary cash to use by distributing dividends to investors, engaging in strategic M&A transactions, or paying down their debt? Of course not! Direct investment by the firms that repatriate cash is not the only way to create jobs and stimulate the economy. Dividends, cash merger consideration, and interest/principal repayment give shareholders and creditors the same opportunity to raise demand in the economy or invest in other companies that might create jobs. Money does not necessarily vanish from the economy if a firm doesn’t directly invest in job creation.
While there is no guarantee that repatriation will galvanize the economy, many key players stand to benefit. The IRS gets revenue it probably wouldn’t otherwise see given the taxpayer-friendly deferral regime. MNEs get tax breaks and freer access to their cash. Investors and other stakeholders get paid earlier or with increasing returns.
As they say, a rising tide…
Kailey Flanagan is a second-year student at Columbia Law School and a staff editor for the Journal of Transnational Law. She graduated from Georgetown University’s Edmund A. Walsh School of Foreign Service in 2012 with a BSFS in International Politics and a certificate in International Business Diplomacy. Prior to law school, Kailey worked as a global transfer pricing consultant for Deloitte Tax LLP.
Author’s Note: Thanks to Professor Robert Scarborough for his very helpful feedback on certain technical aspects of this blog post. All mistakes are my own.