A New Framework For International Tax Reform?

Jul 10, 2015

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Yesterday, Senators Schumer and Portman, as part of a bipartisan tax working group, introduced a set of international tax reform proposals in an effort to “allow the United States to compete on a level playing field” and raise revenues for domestic projects. The proposals include a one-time tax on corporate profits repatriated to the U.S. by companies’ foreign subsidiaries and a “patent box” regime designed to encourage ownership and development of intellectual property in the U.S. While international harmonization of tax codes is a useful goal, these proposals raise some interesting issues to consider.

Repatriation of Profits
U.S. multinationals now earn a majority of their income overseas. According to the report, there is a “lock-out effect” whereby publicly traded firms have incentives to make foreign, rather than domestic, investments and to reinvest those earnings overseas rather than repatriate them. From the strict perspective of tax incentives, this may well be true and some U.S. multinationals may repatriate substantial amounts if the proposal were enacted. However, the ultimate volume of profits that will be repatriated under the proposal is not clear. The reason for this uncertainty lies in U.S. multinationals’ motivation for investing overseas in the first place. Some multinational companies’ investments overseas are made because opportunities to expand sales of existing products may be exhausted in the U.S., but growth opportunities may still be available in foreign countries. If such companies have business operations that are truly global, it may make sense to keep profits overseas to fund future overseas investments. Consider, for example, a company that earns substantial profits in Spain, where it manufactures a product that has growing demand in Europe. If the growth in demand is sufficient to require expansion of the Spanish manufacturing facility, it may make economic sense to use the profits from European sales to fund that expansion.

Another reason multinationals invest profits overseas is to realize efficiencies. Economic conditions, such as availability of inexpensive land or labor, proximity to natural resources, or tax or other financial incentives, can lower the cost of production and increase profits. Of course, taking advantage of these opportunities requires capital, and profits earned in that country are a ready source of capital. Such investments are often perceived as moving jobs from the U.S. to another country, but that is not necessarily the case. According to a study published in the American Economic Review [Desai, Mihir A., C. Fritz Foley and James R. Hines, Jr. "Foreign Direct Investment And The Domestic Capital Stock," American Economic Review, 2005, v95(2,May), 33-38], the story appears to be more complex than build a plant in location A or location B. Rather, the authors of the study found that every $1.00 of additional foreign capital spending is associated with $3.50 in incremental domestic capital spending. To see how this might work, consider what could happen if a company is able to lower its costs and prices. Lower prices may increase purchases of the product, resulting in the need for additional investment in infrastructure and hiring in areas such as sales, marketing, warehousing, shipping and distribution, and customer service.

Joining in the “Patent Box” Movement
Some companies have intangible assets that are highly mobile and can earn profits in a number of jurisdictions. In such cases, a company can choose to own, fund, and develop an intangible in a particular country and then license it to related entities around the world. For example, according to the report, under the current regime a company can own and develop intellectual property in France and pay a tax rate of only 15 percent on certain profits related to that asset—the standard corporate tax rate in France is 38 percent. Clearly, France is providing an incentive to own and develop intangibles in France. If the U.S. institutes a similar arrangement that lowers the tax rate on profits attributable to, say, 15 percent, there would be no tax-driven incentive to move R&D activities from the U.S. to France. While implementation of a patent box in the U.S. may seem simple, questions remain as to issues such as what the appropriate tax rate should be (other countries have single-digit patent box tax rates), and what types of activities would be required to be eligible to obtain this favorable tax treatment.

The proposals advanced by Senators Schumer and Portman provide concrete steps toward making the international tax code in the U.S. more consistent with that in other countries. As with many tax issues, the effect of these proposals, should they be implemented, remains to be seen. Nevertheless, as the committee report stated, “fixing the international tax code won’t be easy, but it will be essential if we want U.S. businesses and their workers to be able to compete and win in an increasingly global economy.”

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