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Earnings Stripping, Competitiveness, and the Drive to Further Complicate the Corporate Tax

5 min readBy: William McBride

Ed Kleinbard, a law professor at the University of Southern California, has a new paper in which he claims that the recent wave of corporate inversions is not about competitiveness, even though the U.S. has the third highest corporate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. rate in the world combined with exceptionally high repatriation taxes. Instead, he argues, corporations find ways around the U.S. corporate tax and the solution is to beef up the rules:

The recent surge in interest in inversion transactions is explained primarily by U.S. based multinational firms’ increasingly desperate efforts to find a use for their stockpiles of offshore cash (now totaling around $1 trillion), and by a desire to “strip” income from the U.S. domestic tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. through intragroup interest payments to a new parent company located in a lower-taxed foreign jurisdiction. These motives play out against a backdrop of corporate existential despair over the political prospects for tax reform, or for a second “repatriationTax repatriation is the process by which multinational companies bring overseas earnings back to the home country. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), the U.S. tax code created major disincentives for U.S. companies to repatriate their earnings. Changes from the TCJA eliminate these disincentives. tax holiday” of the sort offered by Congress in 2004.

Kleinbard proposes the following solutions:

The first component of the necessary legislative package is the most obvious: revise section 7874 so that it parallels domestic law’s consolidated tax return principles, by treating a “reverse acquisition” of a U.S. firm by a smaller foreign firm as a continuation of the U.S. firm for U.S. tax purposes.

The second component, which has very recently gained traction among some members of Congress, is to lower the excessively generous ceiling that section 163(j) sets on the quantum of U.S. corporate tax base erosion that we will tolerate in respect of U.S. domestic earnings.

The final necessary component of any legislative response to inversion transactions is an anti-hopscotch rule.

Kleinbard doesn’t seem to think it problematic to further increase the complexity of the U.S. corporate tax code with these rules. Does he not recognize that such complexity increases compliance costs? Who does he think bears the compliance costs if not corporations, which is to say corporate employees and shareholders? Does Kleinbard not know that tax complexity is an important dimension of competitiveness?

The World Economic Forum (WEF) does. Every year they publish the Global Competitiveness Index, which ranks 148 countries on a multitude of factors including many related to tax rates and tax regulation. While the U.S. ranks 5th most competitive overall, it ranks extremely poorly in terms of tax rates and tax regulations.

The U.S. ranks 107 in terms of the total tax rate on profits. The U.S. ranks 40th in terms of the effect of taxation on incentives to invest, and 38th in terms of the effect of taxation on incentives to work.

The U.S. ranks 55th in terms of the business impact of rules on foreign direct investment, some of which are the tax rules that Professor Kleinbard would like to make more complex and burdensome.

The WEF also asks a random sample of business executives in each country what are the most problematic factors for doing business. In the U.S., the most problematic factor is tax regulations, followed by tax rates. Third most problematic is the inefficiency of government bureaucracy.

This Global Competitiveness Index is probably the most systematic and respected international ranking of business tax regulations, so one would think Kleinbard would make some reference to it. (The World Bank’s Doing Business report is another one, but it only deals with domestic firms. On that score, the U.S. also ranks poorly).

There are many international rankings of corporate effective tax rates, done by prominent academic researchers, and all find the U.S. has one of the highest corporate tax burdens in the developed world, if not the highest. Kleinbard does not refer to any of these, but instead refers to a flawed analysis by the GAO, which claims the U.S. corporate effective tax rate is 12.6 percent, about half what other studies find. If the corporate effective tax rate were really that low, companies would be moving to the U.S. rather than away.

Kleinbard acknowledges that most countries outside the U.S. have territorial tax systems, which means they largely exempt foreign profits from domestic tax, while the U.S. has a worldwide system that taxes earnings no matter where they are earned. However, he claims this distinction doesn’t matter for competitiveness because the U.S. has an “ersatz territorial” system in that U.S.-based multinationals can use deferral to leave their profits offshore and thus avoid the repatriation tax of our territorial system. He argues that U.S.-based multinationals can access their foreign cash “tax-free” by borrowing against it and using the interest deductions against domestic profits. Kleinbard forgets that such a transaction involves paying interest to a bank, which means the bank has to pay tax on the interest income. It also involves risk and paying for the overhead of the bank’s services. This is why economists estimate the effective cost of accessing offshore profits is about 5 to 7 percent, not zero.

Kleinbard also claims that other countries with territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. s have stricter anti-abuse rules than those found in the U.S., without referring to any other country’s rules. In fact, it appears the rules in other countries are less strict. For example, the U.K. does not have a specific rule regarding thin-capitalization to prevent “earnings stripping”, instead relying on standard transfer pricing rules. Most countries, such as Ireland, have nothing to compare to our complicated Subpart F rules.

Instead, these countries have found the best way to combat abuse, a.k.a. profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. a.k.a. base-erosion, is to lower the corporate tax rate and switch to a territorial tax system. That is, they have made their corporate tax systems more competitive, thus removing the incentive for shifting profits offshore.

It is unfortunate that Professor Kleinbard failed to mention any of these important facts regarding competitiveness. It is a rather important issue after all, affecting the lives of millions of U.S. workers who are employed by U.S. corporations.

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