Inversions under the New Tax Law
March 13, 2018
Last week, Ohio-based Dana Inc. announced that it is planning on moving its headquarters to the United Kingdom. In The Wall Street Journal, the CFO said that “even with the new tax legislation, there is a benefit for us.” The company expects that even under the Tax Cuts and Jobs Act (TCJA), this move will reduce its tax liability by around $600 million over several years.
This news is somewhat surprising to some given that a key feature of the TCJA, the move to a “territorial” system, was meant to reduce or eliminate the incentive for companies to invert to avoid U.S. taxes on foreign income. A territorial tax system should make companies with foreign profits indifferent to the location of their headquarters. However, no territorial tax system, including the U.S.’s new code, completely eliminates this incentive. As such, it isn’t surprising that some companies may still see tax savings from moving their headquarters to another tax jurisdiction.
Over the past decade, several dozen companies have “inverted” or moved their headquarters to foreign jurisdictions to avoid U.S. tax liability. One of the major drivers behind inversions was the “worldwide” U.S. corporate tax system, which subjected U.S. multinationals’ worldwide profits to domestic taxation.
Under the old “worldwide” system, a U.S. company doing business in the UK first paid the British corporate tax of 19 percent. When the U.S. company paid those profits back to the U.S., those profits were subject to U.S. tax equal to the difference between the U.S. rate of 35 percent and the British rate of 19 percent.
The goal of this system was to make sure that all profits of U.S. multinational corporations faced a tax rate of no less than 35 percent. However, U.S. companies could avoid the additional tax burden on their foreign profits by moving their headquarters to another jurisdiction.
The TCJA addressed this incentive by introducing what is called a “territorial” tax system. Under a territorial tax system, U.S. multinational corporations would no longer face an additional domestic tax on their foreign profits when those profits were brought back to the United States. This is done through what is called a “participation exemption.” In 2017, 29 of the 35-member nations of the Organisation for Economic Co-operation and Development (OECD) had systems like this.
The reason that a territorial tax system eliminates the incentive to invert is because a company’s U.S. tax liability on foreign profits would be zero regardless of its headquarters location. A U.S. company doing business in the UK would still face the British tax of 19 percent on its income from the UK. It would also face the U.S. tax on its domestic profits. However, it would no longer need to pay an additional domestic tax on its foreign profits. As such, its tax situation would be the same whether it was an American-based company or a British-based company.
This simple analysis works well for an idealized or “pure” territorial tax system. However, there really is no such thing as a “pure” territorial tax system. Most territorial tax systems in the OECD have some worldwide features. For example, most countries subject their domestic multinational corporations to what are called “CFC rules.” CFC rules generally outline policies for taxing the undistributed foreign income of domestic corporations.
The reason countries have territorial systems with worldwide features, such as CFC rules, is that it is very hard to get a territorial tax system right in practice. The goal of a territorial tax system is to tax profits based on the location of production, but this is very hard to do. Companies with multinational production processes take deductions and report revenues throughout the world to allocate their profits. At times it can be very hard to determine exactly how much profit should be taxed in a given country. This leaves room for companies to take advantage of the complexity of cross-border pricing to allocate revenues and costs in tax jurisdictions in a way that can limit their worldwide tax liability. Specifically, companies face incentives to realize revenue in low-tax jurisdictions and incur costs in high-tax jurisdictions.
The new U.S. territorial tax system addresses this concern with new worldwide-system-like features. Specifically, the law introduced a minimum tax on foreign-source profits called “GILTI.” Under GILTI, high-return foreign profits of U.S. multinationals are subject to annual U.S. taxation at a 10.5 percent rate. The foreign tax credit would be limited to 80 percent of foreign taxes paid on those profits. In addition, the new law would provide a reduced rate (13.125 percent) to export-related high-return profits called “FDII.”
“GILTI” and “FDII” are meant to act as a “carrot and stick” for highly mobile income and an additional backstop to the new territorial tax system.
However, this new worldwide backstop comes with a downside: the new minimum tax only applies to companies based in the United States. A U.S. company could potentially avoid this regime by shifting its headquarters out of the United States, a feature of the previous worldwide tax system.
Yet, it is unclear that the incentive to invert will be as widespread as the previous worldwide system. The new minimum tax subjects foreign profits to a lower tax rate: 10.5 percent (with a limited foreign tax credit) vs. 35 percent. And the tax only applies to returns over 10 percent instead of all profits. However, this new tax is applied every year whether or not the profits are paid back to the United States. Under the previous law, companies could defer the additional tax on foreign profits as long as they kept those profits reinvested overseas.
Corporate taxation is inherently complex and lawmakers putting together the TCJA had to make important trade-offs. The new territorial tax system does move us more in line with our trading partners and it should reduce the incentive for many companies to shift their headquarters out of the United States. However, it was inevitable that the new system would come with new anti-base erosion provisions. These new provisions preserve some of the incentives from the previous worldwide system, so it is not surprising that some companies may still benefit from inverting.
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