Tax Expenditure of the Week: Offshore Tax Deferral
Counting Down the Country’s Biggest Tax Breaks, Week by Week
This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average citizen can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.
This week we’re looking at the feature of the tax code that allows U.S. corporations to defer paying taxes on their offshore profits.
What is offshore “deferral”?
The United States has a worldwide tax system. That means U.S. citizens and companies generally must pay federal income taxes on all their income, wherever in the world they earn it. The feature of the tax system known as “deferral” allows U.S. multinational companies to delay paying U.S. taxes on overseas profits as long as they keep those profits offshore.
U.S. corporations take advantage of this tax deferral by forming subsidiaries in the countries where they do business. Foreign subsidiaries are not considered U.S. corporations even if wholly owned by a U.S. parent, so their overseas profits aren’t subject to U.S. taxes.
The key feature of deferral is that the U.S. parent need not pay taxes on a subsidiary’s offshore profits unless and until the profits are returned to the United States—for example, when the subsidiary pays dividends to the parent. At that point, the U.S. parent gets a tax credit for foreign taxes paid but it still has to pay the difference between the U.S. tax and the foreign tax.
Deferral provides tax incentives for overseas investments. In fact, it encourages U.S. companies to make job-creating investments off shore even if similar investments in the United States (absent tax considerations) would be more profitable. “U.S. tax law provides a large tax advantage for building and moving factories to low-tax countries,” according to economist Martin Sullivan.
How much does it cost?
The Treasury Department estimates the federal government will forfeit $42 billion in revenue in fiscal year 2012, and $213 billion over the next five years, because of this deferral.
Why is it a tax expenditure?
Tax expenditures are special rules or exceptions in the tax code that benefit certain taxpayers and cost the government revenue. The ability to defer taxes—to pay them in a later year or not at all—is one of the most common types of tax expenditures.
Who benefits from offshore deferral?
Deferral is valuable to U.S. corporations with global operations because they can delay paying taxes on their overseas earnings for many years, even indefinitely. The rule is particularly lucrative for corporations with income in low-tax countries.
This tax rule is one of the main reasons American corporations pay low taxes by historical and international standards, despite our having a marginal corporate tax rate of 35 percent. There are vast disparities across industries, with some industries paying exceedingly low average tax rates while others pay rates that are closer to (but still less than) the 35 percent marginal tax rate.
Some of the largest and most profitable U.S. corporations pay exceedingly low tax rates through their use of subsidiaries in so-called tax haven countries. Eighty-three of the United States’s 100 biggest public companies have subsidiaries in countries that are listed as tax havens or financial privacy jurisdictions, according to the Government Accountability Office. One study found that the United States loses about $60 billion in revenue each year because of tax-motivated “income shifting.”
What’s the argument for allowing U.S. multinationals to defer their taxes?
U.S. multinationals maintain that deferral of taxes on foreign earnings keeps them competitive in world markets with rivals whose home countries do not tax foreign profits. Most developed countries have so-called territorial systems that exempt their multinationals’ foreign profits even when brought home (which is what many U.S. multinationals would prefer).
U.S. corporations often argue foreign investment is good for domestic job creation because American workers are needed to produce the goods and services that are sold in foreign markets. In recent years, however, U.S. multinationals have reduced domestic employment while increasing foreign employment.
Companies also argue the current system deters them from bringing back and investing their foreign profits in the United States because doing so subjects those profits to U.S. taxes. Of course, that complaint is also a good argument for eliminating deferral. If income were taxed overseas as it was earned, then so-called “repatriation” wouldn’t have any tax consequences.
Deferral also encourages companies to use accounting techniques to record profits offshore, even if they keep actual investment and jobs in the United States. This explains why U.S. corporations report their largest profits in low-tax countries like the Netherlands, Luxembourg, and Bermuda, though clearly that is not where most real economic activity occurs.
What is the role of deferral in corporate tax reform?
In his State of the Union address in January, President Obama called for overall corporate tax reform, and both houses of Congress have begun hearings.
As policymakers consider the issues involved, they should keep in mind that U.S. companies’ global competitiveness is important, but not the only concern. Taxing foreign and domestic investments differently distorts companies’ incentives and impacts economic growth and job creation in the United States.
Moreover, declining corporate tax revenue has worsened deficits, which also threaten economic growth if not brought under control over the long term.
In the debate over whether to exempt overseas profits, it’s critical to recognize that U.S. multinationals often receive an even better deal from our current system than they would under a well-functioning territorial system. That’s because our current system allows companies to combine tax deferral with a wide selection of other loopholes. Corporate tax reform is an opportunity to close some of these loopholes.
For example, one of the most illogical aspects of our current system is that companies can take immediate deductions against U.S. taxes for expenses that support tax-deferred overseas profits. In other words, they can take the write-off now but pay taxes on the resulting income later, if at all.
President Obama has proposed fixing this mismatch. Under his proposal, if the income is deferred, then related deductions must be deferred as well. But Congress has not acted on this proposal or most of his other ideas to close international loopholes.
Bottom line: Deferral of overseas profits is a substantial tax expenditure, representing a $42 billion subsidy for overseas investment. Deferral deserves greater scrutiny, and the many other loopholes corporations use to take advantage of deferral should be considered in any discussion of corporate tax reform.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions. This series continues next week with a closer look at accelerated depreciation.
. To protect taxpayers from double taxation, they can claim a credit for taxes imposed by foreign governments.
. This treatment is in general restricted to profits from active business operations. A part of the tax code known as Subpart F requires U.S. corporations to pay taxes on their subsidiaries’ “passive” income, such as interest or dividends, in the year when it is earned.
. Martin A. Sullivan, Testimony before the House Ways and Means Committee, Hearing on the Current Federal Income Tax and the Need for Reform, January 20, 2011.
. Some of the revenue loss, in theory, is paid back in later years. The Treasury Department estimates the “present value” of the tax expenditure in fiscal year 2010 was $23 billion.
. A recent report by the Center on Budget and Policy Priorities finds that corporate tax revenues as a share of gross domestic product have plummeted to historical lows; meanwhile, U.S. corporations paid an average effective rate of 13.4 percent over 2000–2005, nearly three points below the OECD average. See: Chuck Marr and Brian Highsmith, “Six Tests for Corporate Tax Reform” (Washington: Center on Budget and Policy Priorities, 2011).
. Kimberly A. Clausing, “Multinational Firm Tax Avoidance and Tax Policy,” National Tax Journal 62 (4) (2009): 703–725.
. Of the 10 jurisdictions where U.S. corporations reported the largest shares of their overall income, eight have effective tax rates under 10 percent: the Netherlands, Luxembourg, Bermuda, Ireland, Switzerland, Singapore, the U.K. Islands, and Belgium. See: Clausing, “Multinational Firm Tax Avoidance and Tax Policy.” When the United States declared a dividend “repatriation” holiday in 2004, fully 70 percent of the repatriated profits came from the Netherlands, Switzerland, Bermuda, Ireland, Luxembourg, and the Cayman Islands.
. J. Clifton Fleming Jr., Robert J. Peroni, and Stephen E. Shay, “Worse Than Exemption,” Emory Law Journal 59 (1) (2009).
To speak with our experts on this topic, please contact:
Print: Katie Peters (economy, education, health care, gun-violence prevention)
202.741.6285 or firstname.lastname@example.org
Print: Anne Shoup (foreign policy and national security, energy, LGBT issues)
202.481.7146 or email@example.com
Print: Crystal Patterson (immigration)
202.478.6350 or firstname.lastname@example.org
Print: Madeline Meth (women's issues, poverty, Legal Progress)
202.741.6277 or email@example.com
Print: Tanya Arditi (Spanish language and ethnic media)
202.741.6258 or firstname.lastname@example.org
TV: Lindsay Hamilton
202.483.2675 or email@example.com
Radio: Madeline Meth
202.741.6277 or firstname.lastname@example.org
Web: Andrea Peterson
202.481.8119 or email@example.com