Congressional Research Service Advice to Congress and President Trump on Tax Reform
Everyone, it seems, has an opinion on tax reform. It is interesting to see what the Congressional Research Service (CRS) has to say because they are normally seen as a neutral, non-political source of information. Among other considerations, the CRS says tax law changes could impact the deficit and debt, domestic job markets, competitiveness, and the use of corporate tax havens.
CRS examines global corporate tax issues on the brink of likely reform
With Donald Trump firmly in office as the U.S. president, and a Republican majority in Congress, it has been widely expected that 2017 will bring significant tax reform. Recent political issues may challenge this conventional thinking.
The CRS 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.
Because of the relatively high corporate tax rate and double tax system in the US, many US operations are conducted as flow through entities (as partnerships or LLCs) to avoid the double tax. This is the case even if owning foreign legal entities, because under the “Check-the-box” system, these foreign entities can be treated as flow through for US tax purposes (claiming a foreign tax credit against the higher US tax rate).
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.
While it may be prudent to defer any major restructuring until a better picture of US tax reform emerges, you should at least be considering your options presently so that you can act quickly when change come (or do not happen). Contact us when we can be of assistance.
James J. Miesowicz, CPA
Jim Miesowicz has significant experience in helping foreign-owned U.S. entities with a variety of inbound international issues and working with foreign nationals. He offers assistance with structuring international business operations and investments. Jim provides guidance with international inbound and outbound transactions, as well as assisting U.S. companies with establishing operations outside the U.S. Contact Jim at email@example.com or 248.244.3115.