This week, President Obama released his fiscal year 2016 budget. Among the 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. increases he previously announced, he has proposed several tax changes that will affect U.S. multinational corporations that operate overseas. Although the proposal would lower the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate to 28 percent, it would eliminate the deferral of domestic taxation of foreign income and enact a foreign minimum tax of 19 percent (with an allowance for corporate equity). The plan would also toughen many anti-abuse provisions in the tax code.
Current U.S. Tax Code
The current U.S. corporate tax code taxes all corporate income, earned in the United States or abroad, at the 35 percent federal corporate tax rate. For U.S. corporations earning income overseas, they must pay the income tax in the country where they earned the income, then pay the difference between that country’s tax rate and the U.S. rate. For example, a U.S. company in England must pay 21 percent to the British government. Then, the corporation must pay 14 percent to the U.S. government (35 minus 21 percent).
However, U.S. corporations can delay paying the additional tax to the U.S. government as long as that income is reinvested in ongoing foreign operations. Passive income (investment income), however, earned overseas is taxed immediately by the U.S. government whether it is brought back to the United States or not.
The President’s budget would lower the top marginal corporate income tax rate to 28 percent. On top of reducing the rate, the budget would alter how corporations are taxed by the U.S. government when they earn income overseas.
First, the proposal would eliminate deferral. Corporations would owe U.S. tax on foreign income on a current basis.
However, his proposal would create a minimum tax on foreign earnings, which would limit the domestic tax on foreign earned income that has faced a sufficient tax rate overseas. If the income did not face a high enough tax rate overseas, then additional tax would need to be paid to the U.S. government. The proposal includes a formula for companies to determine whether or not they need to pay additional tax to the U.S.
The formula to determine whether the income has faced a sufficient tax is 19 percent (the minimum tax rate) minus 85 percent of the effective tax rate in a given country (over a 60 month period). For example, a U.S. corporation that earned income in the United Kingdom would face a 21 percent corporate tax rate. 19 percent minus 17.85 percent (85 percent of 21 percent) = 1.15 percent, thus the U.S. corporation would be required to pay an estimated 1.15 percent to the United States’ government.
The estimated tax rate would then be reduced by an “allowance for corporate equity.” This allowance provides a tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. on income based on a risk free return on active investments overseas. So in the case of a corporation doing business in the United Kingdom, the allowance may reduce the tentative minimum tax bill of 1.15 percent to zero. Thus, the United States would not tax the income earned in the United Kingdom further.
On top of the changes to the international tax system, the proposal would strengthen several anti-abuse policies. The plan would alter Thin-Capitalization rules to limit the amount of interest a U.S. corporation can deduct from U.S. taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . Additionally, anti-inversion rules would be made more stringent among other changes to international tax rules.
A Significant Change, but Not the Improvement We Need
This proposal is a drastic change in the way the United States taxes overseas income. This plan will undoubtedly affect most, if not all, businesses operating overseas. Some businesses may see improved treatment due to a combination of a lower domestic tax rate (28 percent) and a minimum tax that would not affect them, especially companies operating in high-tax countries. However, some corporations that do business in low-tax countries may see high tax bills when hit by the new minimum tax and the lack of deferral. Additionally, the provisions seem unnecessarily complex and overly restrictive, such as the allowance for corporate equity and the strengthened anti-inversion rules.
Although the president’s proposal to change the international tax system is a departure from the current system and some business income may see lower tax burdens, it isn’t the massive improvement needed in a fundamental tax reform.
Rather than moving to exempt all foreign earned income from domestic taxation, the proposal seems overly occupied with the effective tax rates faced by U.S. corporations in foreign countries. The proposal would force businesses to make investment decisions based on the minimum tax and a complex “corporate allowance,” rather than on the economic and fiscal environment of a given country.
An ideal 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. would only concern itself with the income earned within the United States. Only this way would U.S. businesses be able to invest freely in the U.S. and abroad and compete globally without having to worry about an additional U.S. tax burden.Share