Democratic congressmen are interested in changing the tax rules for foreign earnings of US multinational companies. They claim that the current rules encourage US companies to outsource and offshore what would otherwise be US jobs and investments. However, closer inspection shows that these claims are not consistent with the way the rules worked.
Some lawmakers are focusing on a guideline introduced in the Tax Cuts and Jobs Act (TCJA) of 2017 known as Global Intangible Low Tax Income (GILTI). US taxes on GILTI result in a minimum tax on foreign income. Lawmakers claim that companies may choose to invest overseas and pay the tax on GILTI rather than pay US tax at 21 percent because GILTI can be taxed by the US at a low rate of 10.5 percent .
Lawmakers are also addressing the 10 percent foreign asset deduction that is part of the GILTI calculation, proposing that the deduction and lower tax rate on GILTI provide incentives for offshore investment and employment.
In considering these arguments, it is worth examining how the taxation of GILTI works in the context of the overall 2017 reform.
First, the US tax on GILTI is in addition to the foreign taxes that US companies pay on their foreign profits. Typically, corporations can claim foreign tax credits to reduce their tax liability to the IRS. However, taxes on GILTI can only be credited up to 80 percent of the value of the foreign taxes paid. A company that pays $5 in foreign taxes and then owes $5 under GILTI can only claim a $4 tax credit, leaving the company with a total tax liability of $6. GILTI was designed to have a lower effective tax rate to avoid total double taxation of foreign income, but US corporations that pay both foreign taxes and taxes on GILTI are subject to two tiers of taxation.
Additional foreign tax regulations can result in much higher effective tax rates on GILTI, even in the high teens. Just looking at the potential tax rate on GILTI of 10.5 percent doesn’t show the whole picture.
Second, GILTI was a net tax increase under the Tax Cuts and Jobs Act. The Joint Committee on Taxation (JCT) estimated that the tax on GILTI would generate $112 billion over the period 2018-2027. If the preference for businesses was so favorable compared to previous rules, the estimated increase in revenue makes little sense. As part of the tax reform, GILTI has significantly broadened the US tax base. Instead of the previous rules that taxed foreign income from royalties or dividends and on repatriation of foreign income, GILTI now applies generally and annually to US corporations’ foreign income.
Third, GILTI’s 10 percent foreign tangible assets deduction does not provide a clear incentive for companies to choose to invest or hire overseas rather than in the United States. The GILTI tax base excludes gains equivalent to a 10 percent return on tangible assets. Critics point out, saying that increasing foreign tangible assets reduces the amount of foreign profits taxed under GILTI and therefore gives companies an incentive to move their investments abroad. However, a company that chooses to invest abroad rather than in the US would have to believe that the foreign tax treatment of that investment – not just the GILTI treatment – would be better if it made its investment outside of the US
The Tax Cuts and Employment Act significantly reduces taxes on corporate profits. But the tax cut targeted U.S. profits rather than foreign profits. A recent study by accounting professor Scott Dyreng and his co-authors found that the effective tax rate on US companies’ overseas profits remained roughly unchanged after the tax reform. In fact, they estimate that the combined US and foreign effective tax rate on foreign income is about 28 percent. Meanwhile, the estimated effective tax rate on domestic income has fallen to 17 percent.
To put it bluntly, the Tax Cuts and Jobs Act has made investments in the US much more attractive for companies. The incentives for US multinationals to move jobs and investments abroad or to artificially avoid paying US taxes have changed significantly since the tax reform.
The recently appointed Deputy Assistant Secretary for Tax Analysis, Kimberly Clausing of the Treasury, acknowledges this in a paper assessing the impact of international regulations on the Tax Cuts and Employment Act. She notes that GILTI’s impact on profit shifting will result in a 12 to 16 percent reduction in profits booked in tax havens. This means tax reform will result in companies reporting more taxable profits to the US Treasury rather than avoiding US taxes.
However, Clausing also suggests that the deduction for foreign tangible assets in GILTI will encourage US companies to invest more abroad. Your points are like the arguments of some congressmen. Although a company could increase its foreign tangible assets to partially offset the impact of GILTI, that’s different than saying a company want Do this by choosing to build a factory in another country instead of the US
Profits from a US factory would be taxed at a rate of 21 percent, and capital expense deductions would benefit from US rules for depreciation, including full expenses for machinery. If the company was looking for an investment opportunity abroad, it would need to compare US tax rules with corporate tax rules in foreign jurisdictions.
However, investment decisions are not necessarily zero sums. If an investment in the US would be profitable, but a company chooses to invest elsewhere, it still means that another company has the potential to make a profitable investment in the US
Regarding GILTI, US companies could acquire foreign companies with low profit margins and many tangible assets. Such acquisitions could reduce a company’s exposure to GILTI. A US company that contracts with a distribution facility in France to supply its products to European customers may choose to acquire that distributor. This would not be a net loss of US jobs because the distribution facility serves a foreign market and could make good business sense from both a geographic and tax perspective.
There is some recent evidence that US multinationals are making foreign acquisitions like this one. Accounting professor TJ Atwood and her co-authors conducted recent research showing that companies that were more likely to be subject to taxes on GILTI increased their acquisitions of foreign companies with more tangible assets. A company that has a significant GILTI exposure is likely to be in this position as it derives its foreign income primarily from intangible assets. By acquiring foreign companies with more tangible assets such as factories, processing plants or distribution facilities, a company could dilute its GILTI liability to some extent.
Many members of Congress have criticized the 2017 tax reform. However, the reasoning that has led some to believe that GILTI offers a route to outsourcing investment and jobs is flawed.
That doesn’t mean GILTI is flawless. Problems with how GILTI works in practice tend to inflate the GILTI tax burden. Policymakers should focus on ways to improve US international tax rules, rather than crafting convenient narratives supporting a tax hike on US corporations.