Congress Should Reassess the Importance of Two Corporate Tax Breaks
A series of tax breaks expired at the end of 2013. These tax breaks are all technically temporary, but they are extended so regularly that they are collectively known as the tax extenders. Some of these tax extenders are good policy, such as relief for foreclosure victims, support for energy efficiency and renewable energy, incentives for businesses to hire disadvantaged workers and veterans, and tax credits to revitalize economically depressed areas. Other tax extenders, however, offer fewer public benefits and primarily subsidize big multinational corporations.
The federal government spends more than $1 trillion through the tax code every year due to all of the tax breaks, subsidies, and loopholes that Congress has created. Altogether, the tax extenders package cost about $76 billion the last time it was extended for 2012 and 2013 as part of the fiscal cliff deal. Some tax expenditures are justified, but all of them should receive the same scrutiny that is applied to the rest of the government’s spending. Consider this: At the same time the tax extenders expired, long-term unemployment benefits also expired. As a result, 1.3 million jobless workers and their families lost their benefits immediately, with the number growing to more than 2 million since then. But while spending to help the unemployed has been greeted with harsh skepticism in some quarters, spending through the tax code often occurs with little to no inspection from politicians.
Two tax extenders in particular, known as the “active financing” and “look-through” exceptions, deserve greater scrutiny than Congress has applied in the past. Understanding these two tax extenders requires some background on U.S. tax rules for multinational corporations. In general, the taxation of foreign subsidiaries of U.S. corporations can be deferred until the subsidiary returns its profits to its U.S. parent corporation. However, taxes must be paid immediately on foreign earnings from interest, dividends, rents, and royalties. Those earnings are considered passive income, and corporations can easily shift them from one country to another. If the United States did not tax passive income immediately, corporations would have the ability and incentive to shift this income into foreign tax havens to avoid paying taxes.
The active financing exception allows multinational financial institutions to treat their foreign banking and insurance earnings as active income, even though their income flows from sources that would normally be considered passive income. This means that these corporations can defer U.S. taxes on their foreign profits. If an Irish subsidiary of a U.S. corporation simply collects income from a portfolio of Irish stocks and bonds, for example, those gains are taxed in the United States immediately. But if the Irish subsidiary loans money directly to Irish businesses, the active financing exception allows it to defer U.S. taxes. This exception cost the government $11.2 billion in tax revenues when it was extended for two years as part of the fiscal cliff deal.
Multinational financial institutions argue that since they get their interest income from active business operations such as direct loans, those interest payments should be considered active income on which taxes can be deferred. The mobile nature of active financing activities, however, has worried lawmakers in the past. When Congress eliminated an ancestor of the active financing exception in the 1986 Tax Reform Act, the Joint Committee on Taxation explained:
The lending of money is an activity that can often be located in any convenient jurisdiction, simply by incorporating an entity in that jurisdiction and booking loans through that entity, even if the source of the funds, the use of the funds, and substantial activities connected with the loans are located elsewhere. The proliferation of U.S.-controlled banking and insurance companies in various tax haven jurisdictions suggested that many taxpayers were in fact taking advantage of the ability to earn dividends, interest, and gains through such entities, on which the U.S. tax was deferred and the foreign tax was often insignificant.
After the passage of the Tax Reform Act of 1986, the active financing exception was repealed for about one decade. Congress revived it on a temporary basis in 1997, made technical changes to tighten up the rules defining active financing activities in 1998, and has routinely extended it since then to prevent its expiration. Those technical changes made the active financing exception less open to abuse, but a U.S. Treasury Department study from 2000 warned that flaws still remained despite the detailed rules.
The second temporary corporate tax break in need of increased scrutiny is the look-through exception. This rule allows corporations to treat a foreign subsidiary’s passive income as active income if it came from another foreign subsidiary’s active business. For instance, if a U.S. manufacturer had a distribution arm in Germany that was financed through a finance arm in Bermuda, then interest payments from the German subsidiary to the Bermudan subsidiary would not be taxed as current income in the United States. The two-year extension of this look-through treatment in the fiscal cliff deal cost the United States $1.5 billion.
The look-through rule encourages U.S. corporations to shift their foreign income from high-tax countries to low-tax countries. This means that corporations are making investment decisions to minimize their tax bills, not to maximize economic value. Multinational corporations argue that the U.S. tax system should not concern itself with transfers between foreign subsidiaries, which primarily serve to lower foreign tax bills rather than U.S. taxes. Look-through treatment, however, subsidizes foreign tax avoidance—hardly an activity that the United States should encourage.
Congress should compare the extension of these provisions with other kinds of government spending when determining their fate. While corporations maintain that these tax breaks help them compete abroad, that money may be better used for building infrastructure, strengthening preschool education, or delivering desperately needed assistance to the long-term unemployed here at home.
Republicans in the House, however, have blocked an extension of long-term unemployment benefits, insisting that spending on these benefits must be paid for with cuts elsewhere in the budget. While a bipartisan group of senators has finally reached a deal to renew unemployment benefits, conservative lawmakers appear likely to block this legislation in the House, with Rep. Peter Roskam (R-IL) insisting on a “high level of scrutiny on the level of the pay-for.” Yet Congress might pass the tax extenders—including the active financing and look-through exceptions—without paying for them at all. The last two-year extension of these two corporate tax breaks cost more than the five-month extension of long-term unemployment benefits in the Senate agreement.
Short-term deficits are low and stable, and there is no need to “pay for” extended unemployment benefits. Long-term unemployment is a human and economic catastrophe, and Congress should extend unemployment benefits without delay. If Congress holds up unemployment benefits due to misguided deficit concerns but passes tax breaks for big corporations without worrying about offsetting their cost, the American people will have a deeply troubling window into whose interests matter the most to politicians.
Harry Stein is the Associate Director for Fiscal Policy at the Center for American Progress. John Craig is a Research Assistant in the Economic Policy department at the Center.
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Director, Fiscal Policy