April 1, 2021
Director of Federal Tax Policy
April 1, 2021
The corporate tax plan put forth on Wednesday by President Joe Biden to offset the cost of his infrastructure priorities would be the most significant corporate tax reform in a generation if enacted.
Biden’s proposal to raise the statutory corporate tax rate from 21 percent to 28 percent is what most people will remember. But the statutory tax rate means little if companies avoid paying it. Biden’s plan would eliminate many special breaks and loopholes and, as a result, would likely end the corporate tax dodging that ITEP has identified under the Trump tax law and the law that preceded it.
The techniques corporations use to avoid taxes can be conceptually split into two categories—offshore corporate tax breaks and domestic corporate tax breaks. Biden’s proposals clamp down on both.
Offshore Tax Breaks
Biden proposes to ensure that offshore profits of American corporations are all taxed at a total rate (including foreign taxes and U.S. taxes) of at least 21 percent. This would be true whether a company claims to earn those profits in Canada, a country where U.S. corporations do a lot of business, or the Cayman Islands, where corporations claim to earn impossibly large profits even though there are almost no real business opportunities there.
Like similar proposals in Congress, this would shut down the long-standing problem of American corporations using accounting gimmicks to claim that their profits are earned by subsidiaries in countries with a very low or no corporate tax (countries known as tax havens).
Drafters of the Trump tax law could have stopped this, but instead put in place rules that continue to encourage offshore tax dodging by taxing offshore profits far more lightly than domestic profits. They arguably made the situation worse because these rules encourage American companies to shift real assets and operations—and the jobs that go with them—offshore.
The Trump tax law exempts offshore profits of American corporations from U.S. taxes unless they exceed a 10 percent return on tangible investments held offshore. In other words, a U.S. company does not pay U.S. taxes on profits earned by their offshore subsidiaries unless those profits exceed 10 percent of the tangible assets (machines, factories, office buildings, oil wells) the company has offshore. As a result, a company could avoid U.S. taxes by moving more tangible assets offshore.
For example, consider an American corporation that has operations in the United States and in Ireland. It has $1 billion in tangible assets in Ireland and earns around $150 million there in most years. Of that $150 million, $100 million is exempt (because 10 percent of $1 billion is $100 million), but the remaining $50 million is subject to U.S. taxes. The company might avoid U.S. taxes altogether by moving more operations to Ireland. Increasing its tangible assets held there from $1 billion to $1.5 billion would result in an exemption of $150 million (10 percent of $1.5 billion) from U.S. taxes.
Meanwhile, even offshore profits subject to U.S. taxes (profits that the Trump law calls Global Intangible Low-Taxed Income, or GILTI) receive more favorable treatment than domestic profits. Domestic corporate profits are subject to a rate of 21 percent, while GILTI is effectively taxed at half that rate, just 10.5 percent.
It gets worse. Companies can effectively pay less on their GILTI. American companies can claim a credit against their U.S. taxes for taxes they paid to foreign governments on their offshore profits, the foreign tax credit (FTC). This makes sense because it prevents double taxation. But a long-standing problem is that American companies can pool their profits and losses abroad to calculate their FTCs and U.S. taxes. Effectively this means they use the taxes they pay in high-tax countries to shield their tax haven profits from U.S. taxes.
The bottom line is that the corporate tax system created under the 2017 law rewards corporations that can transform U.S. profits into foreign profits, whether this means shifting profits on paper or moving business operations abroad.
Biden’s proposals would shut down all of this. He proposes to do away with the 10 percent return exemption and subject all offshore profits of American corporations to a rate of 21 percent. They would continue to receive the FTC if they pay taxes to foreign countries where they operate, but only on a country-by-country basis. If their foreign tax rate is less than 21 percent, they would pay the remainder to the United States. They would gain nothing from routing profits through subsidiaries in Bermuda or the Cayman Islands because those profits would be effectively taxed at 21 percent.
Biden’s plan would also address the problem of foreign corporations stripping profits out of the United States, and the related problem of American corporations becoming “foreign” through inversions so that they could do the same thing.
American subsidiaries of foreign corporations sometimes engage in gimmicky transactions to make payments to their parent companies—like an interest payment or a royalty—that the American subsidiary deducts from the income it reports to the IRS. This effectively sends profits out of the country for tax purposes.
The Trump tax law applies a weak minimum tax (called the Base Erosion and Anti-Abuse Tax, or BEAT) that supposedly discourages this. Biden’s plan replaces the BEAT with a stronger measure that denies “deductions to foreign corporations on payments that could allow them to strip profits out of the United States if they are based in a country that does not adopt a strong minimum tax.”
We will need more details before we understand exactly how effective this would be, but it appears that American subsidiaries would not be able to deduct these payments unless the parent corporation is in a country that has a strong minimum tax (perhaps even one comparable to the 21 percent tax the United States would impose on offshore profits). This would remove the benefit of stripping earnings out of the country.
Domestic Corporate Tax Breaks
Corporations can also avoid taxes on profits that they unambiguously earn in the United States, often by using tax breaks enacted by Congress that supposedly encourage some socially desirable activity.
For example, Congress has long allowed accelerated depreciation, writing off the cost of investments in equipment more quickly than it wears out. The Trump law temporarily allows full expensing, meaning companies can deduct the entire cost of an investment the year it is made, which is the most extreme version of accelerated depreciation. This is supposed to help the economy by encouraging investment, but it often rewards companies for making investments they would have made anyway.
Some companies also use a tax break for executive stock options. This allows companies to write off stock-option related expenses for tax purposes that go far beyond the expenses they report to investors.
These are just two examples of many. For the most part, Biden does not propose to change them directly. Instead, he would ensure that even if companies do use these tax breaks, they still pay at least some taxes any year they tell their investors that they are profitable.
He would accomplish this through a minimum tax of 15 percent on corporations’ “book” income, meaning the profits they report to the public and to investors. Corporations would pay whichever is more, their tax liability under the regular corporate tax rules or 15 percent of their book profits.
While corporate leaders are happy to lowball profits they report to the IRS for tax purposes, they never want to lowball profits they report to investors they are trying to attract, which could make minimum tax difficult for corporations to avoid.
A New Era for Corporate Tax Reform
In many cases, Biden’s corporate tax proposals do not go as far as they could but are nonetheless a revolutionary change from the status quo that has calcified over decades.
For example, an ideal reform might tax offshore and domestic profits at the same rate, but under his plan the rate for offshore profits would be three-fourths of the domestic rate (21 percent vs. 28 percent). An ideal plan might also cut out more tax breaks at the root, like the stock options tax break and accelerated depreciation, whereas Biden proposes instead to limit the worst effects of these breaks with a minimum tax.
But Biden’s plan would nonetheless be a sea change if enacted. It would dramatically shrink the vast world of fictitious business transactions between thousands of shell companies that exist, only on paper, to route profits beyond the reach of the society that makes those profits possible. It would end the spectacle of corporations earning huge profits for years while paying effective tax rates that are in the single digits if not zero. That alone would be worth celebrating.
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