Missteps at the Summit on International Taxation

7/13/21

I’ve been reading about the planned summit with 20 major countries scheduled for October. At that time, high on the US agenda will be the imposition of a 15 percent minimum tax rate, worldwide. Presumably, this measure is intended to address the problem of certain countries setting themselves up as tax havens, the consequences of which include (a) allowing multinational corporations to significantly reduce their tax liabilities and (b) fostering some incentives for businesses to offshore some portion of their economic activity. While such an adjustment might seem to address both concerns, in fact, it’s wrong-headed. A much more effective solution is available.

To understand, we need to appreciate that the amount of taxes collected depends on two things: the tax rate, and the amount upon which the tax rate would be applied — i.e., the taxable income. When it comes to the concerns at hand, the issue of taxable income is, or should, bear a greater weight. The real problem at hand is that too much of foreign based income is simply not subject to US taxation. It’s not that the tax rate abroad is too low.

To understand how and why foreign income often avoids US taxation requires consideration of consolidated income. In the general case, companies often operate using special purpose structures like subsidiaries, which are companies that the parent company owns or controls. The consolidated entity includes the parent and all subsidiaries, and their consolidated income includes incomes from all of these components.

To my surprise, however, I’ve learned that companies file a tax return reflecting consolidated income at their discretion. That is, each unit of a consolidated entity may elect to file independently. Moreover, even if the election is made to file a consolidated tax return, the resulting measure of consolidated income is limited to income derived solely from subsidiaries for which the parent company claims 80 percent ownership or more. Thus, if the US corporation with foreign-based income opts out of filing a consolidated tax return or if the income from the foreign source comes from an entity where the parent has less than 80 percent ownership, that particular income component would be explicitly exempted from US taxation. (Income from a US-domiciled company with less than 80 percent ownership by the parent would still be subject to US tax, but under its own filing.)

This feature of the tax code would seem to be responsible for many US companies avoiding their “fair share” of tax liabilities and at least some portion of the outsourcing of American jobs that we’ve experienced. These outcomes have come about not because of low tax rates abroad, but rather because Congress has written rules that effectively allow companies to define substantial amounts of income as “untaxable.” It’s beyond my capabilities to estimate the tax revenues that have been lost due to this definitional feature of the tax law, but it has to be considerable. One more example of corporate welfare at work.

We don’t need an international summit to solve this problem. Congress can fix it on its own. All that would be required is for Congress to redefine taxable income by requiring the corporate tax rate to be applied to all consolidated income from abroad, with no conditionality with respect to percent of ownership.

With this adjustment to the tax code in place, we would still operate under international agreements whereby companies would be granted tax credits for taxes paid to foreign tax authorities. Here’s how it would work: Consider the consolidated entity registered in the US that is subject to a US corporate tax rate of 21 percent, and suppose this company has a subsidiary with less than 80 percent ownership based in Bermuda where the corporate tax rate is 7 percent. Let’s assume the company’s share of the subsidiary’s income is $10 million. This income is currently taxed in Bermuda, but it’s exempt from taxation in the US. Thus, under present law, the company’s entire tax liability from this income is $700 thousand, to be paid to the Bermudian tax authorities.

Under a revised tax treatment in the US, the $10 million Bermudian sourced income would be included as consolidated income and taxed at a rate of 21 percent in the US, fostering a liability of $2.1 million. Because the company pays $700 thousand in Bermuda, however, the US tax authorities would grant a $700 thousand tax credit against the US tax liability. Thus, when all is said and done, the company would pay Bermuda $700 thousand in taxes and $1.4 million to the IRS in the US. The company’s combined tax liability is $2.1 million — exactly what it would be if all the earnings were generated here at home. In other words, the incentive to outsource jobs and economic activity based on tax considerations would be entirely eliminated.

The fix is within our grasp, here at home. I say we should get our own house in order before we go about pressuring other countries as to how to fix theirs — particularly when that purported remedy will likely fall well short of its intended goal.

Kawaller holds a Ph.D. in economics from Purdue University.