Treating Royalties to Governments as the Taxes They Are

March 08, 2011

Yesterday, I discussed the section 199 domestic manufacturing deduction and how it's not quite accurate to call it a fossil fuel subsidy because it's a broadly available deduction that any company can take.

A separate idea that the Administration has proposed in the past is to deny in part to fossil fuel companies the benefit of the similarly broad foreign tax credit. For example, the Environmental Law Institute (PDF) counted up $72.4 billion in fossil fuel subsidies over seven years, with a sizeable $15.3 billion of that representing the foreign tax credit. ELI conceded that the credit "is available generally to all U.S. taxpayers, both corporate and individual" (p. 9). Most countries tax only income earned within their borders, while the U.S. taxes the worldwide income earned by its citizens; the foreign tax credit is one mechanism to ensure U.S. individuals and businesses are not paying tax twice on the same dollar of income.

Oil production involves paying royalties to the owner of the land and taxes to the foreign government. But in most oil-rich countries, the government has nationalized the oil-rich land, so both royalties and taxes are paid to the government, leading to one excessive tax bill. In Saudi Arabia, for instance, one must pay an 85% tax on oil extraction income, compared to 20% for other activities; in Nigeria, 85%, compared to 30% for other activities; in the UAE, 55%-85%, compared to 20% for other activities; and so forth.

The proposal as floated in the past would parse these tax bills into a "royalty" part and a "tax" part, measured by the tax on other activities. So a U.S. oil company doing business in Saudi Arabia would only get to deduct the 20% tax, not the other 65% that would be classified as a royalty. (Our tax code permits 30% deduction for royalty payments, but 100% deduction for taxes paid. Foreign governments have obliged and mostly categorized their huge bites as taxes, not royalties.)

U.S. states, of course, imposed hefty taxes on oil, coal, and mineral extractions, just as foreign countries do. Every serious scholar, including the U.S. Census Bureau, classifies those exactions as taxes (although not income taxes). (Here's our research on identifying a tax.) Denying the credit to fossil fuel companies means that industry would then face paying multiple taxes on the same dollar of income, precisely the problem the foreign tax credit was meant to correct. It's not right to say that taking the foreign tax credit is "avoiding taxes." Those taxes are being paid, just to other countries.

U.S. businesses should either be subject to double taxation on their foreign income, or they shouldn't be. If we want to only give exemptions for income taxes paid, that should be the rule across the board. But it's hard to believe that anything other than animus towards oil companies fuels the idea that we should broadly prevent double-taxation of foreign income, except for fossil fuel companies.

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