With Donald Trump firmly in office as the U.S. president, and a Republican majority in Congress, it’s widely expected that 2017 will bring significant tax reform.
The Congressional Research Service (CRS) recently published a report highlighting several considerations that lawmakers may take into account in tax reform discussions.
Although tax reform often seems like a moving target, congressional Republicans and President Trump have each set out a number of ideas about how to modify the U.S. international corporate system.
Reports indicate that the President and congressional Republicans have begun tax reform discussions. However, what will ultimately be introduced as proposed laws remains to be seen.
Considerations in reforming the system
The report notes that recent deficit reduction and tax reform proposals have raised concerns over how changing the way American multinational corporations are taxed could impact the deficit and debt, domestic job markets, competitiveness, and the use of corporate tax havens, among other things. An informed debate about how to reform the system governing the taxation of U.S. multinational corporations requires careful consideration of these issues, as well as a basic understanding of several features of the current system.
The CRS report highlights the following issues it says should be taken into account in tax reform efforts:
Profit shifting and BEPS
Profit shifting generally refers to corporations’ artificially moving taxable income from high-tax countries to low-tax countries as part of a tax reduction strategy. The following three strategies are among the ways corporations do this:
- They finance operations in high-tax countries with debt in low-tax countries, letting the companies deduct interest in countries where the deductions are most valuable and have income taxed in countries with the lowest rates (“debt shifting”).
- They engage in intracompany transfers of intangible assets and intellectual property such as patents, copyrights, trademarks and trade secrets. The corporations transfer the assets to subsidiaries in low-tax countries and then charge subsidiaries in high-tax countries for using them, thus reducing the high-tax subsidiaries’ taxable income.
- They charge prices that don’t reflect market, or arm’s length, prices for goods transferred between subsidiaries. (The U.S. has transfer pricing rules to ensure that transactions between related subsidiaries occur at market prices, but difficulties arise in several situations, such as when there isn’t any clear market price.)
The Organisation for Economic Co-operation and Development (OECD) has been, at the request of the G20 Finance Ministers, developing the Base Erosion and Profit Shifting (BEPS) Action Plan, which provides 15 detailed actions governments can take to reduce tax avoidance by multinational corporations (as well as individuals) worldwide. Countries are now developing the framework to implement the plan. Some of the actions require coordination and information sharing between governments, and potentially the amendment of existing tax treaties.
Although not discussed in the CRS report, a number of prominent lawmakers have been critical of the BEPS project and its potential impact on U.S. taxpayers. Regardless, the BEPS project will undoubtedly play a significant role in U.S. corporate international tax reform, whether the policies are ultimately adopted or merely influence reform efforts.
Economic incentives and efficiencies
The CRS notes that a pure worldwide tax system promotes “capital export neutrality” — that is, the notion that taxes should be irrelevant to a corporation’s decision to invest at home or overseas. This theoretically should lead corporations to allocate their capital to its most productive use in the world economy. A pure territorial system, on the other hand, exhibits “competitive neutrality,” also known as “capital import neutrality.”
With a pure territorial system, corporations making overseas investments face the same tax rates as foreign competitors in foreign markets, thus removing any tax-based competitive disadvantage of corporations in foreign markets. This system isn’t neutral in an economic sense, however, because it causes more investment in low-tax countries than would occur without taxes. Shifting from a worldwide to a territorial system could alter incentives and impact business decision-making by U.S. corporations.
Statutory vs. effective tax rate
One of the main focal points in the debate over corporate tax reform is whether the top U.S. federal corporate tax rate of 35% is too high relative to the rest of the world. However, because of a number of tax subsidies (deductions, credits, exemptions, etc.) in the corporate tax system, most corporations’ effective tax rate is typically less than the statutory rate, sometimes significantly so — which is true in the U.S. as well as in a number of other countries. Thus, the CRS advises that it’s more appropriate to look at effective tax rates when comparing the U.S. to the rest of the world.
The CRS also noted that effective rates can vary substantially among U.S. corporations and across corporations in the same industry, further complicating a general comparison between U.S. tax rates and those of other countries. For example, some corporations rely more on debt financing, some rely more on machines and facilities that can be depreciated quickly, and some have more extensive overseas operations.
In discussing a lower rate, it is thus important to look beyond the maximum statutory rate in measuring the potential effect of a reduction.
The CRS report also raised a number of other questions that should be considered, including how far the rate can be lowered without negatively affecting the deficit. It also cautioned lawmakers to look out for potential unintended consequences that could result from enacting certain reforms.
Sidebar: Australia says TPP not dead, despite Trump opposition
Australia has declared that the Trans-Pacific Partnership (TPP) isn’t dead despite rejection of the trade pact by U.S. President Donald Trump.
Australian Trade Minister Steven Ciobo explained in a radio interview that, if the pact were rejected, Australia would seek free trade agreements with individual Asian nations. “We will certainly continue to look for trade opportunities. Australia is a trading nation,” he said. The Minister said Australia would also pursue trade agreements with the European Union and the UK.
The 12-member TPP, which aims to cut trade barriers in some of Asia’s fastest-growing economies but doesn’t include China, can’t take effect without the United States. The deal, which has been five years in the making, requires ratification by at least six countries accounting for 85% of the combined gross domestic product of the member nations. Given the sheer size of the American economy, the deal cannot go ahead without U.S. participation, some observers say.
Japan is the only signatory to have ratified the TPP. There is a deadline of February 2018 for all members to sign the pact into law.