Is the Offshore Tax Vacation Over?

Corporate tax reform has been a battle cry in U.S. politics since the 2008 financial crisis when all sides of the political spectrum seized on different facets of corporate and fiscal fairness. Despite the attention over the past five years, however, little progress has been made in overhauling the system.

But a combination of fiscal pressure and political serendipity could mean that significant changes are on the way. And no part of the U.S. corporate tax regime is more at risk of change than corporate offshore tax strategies.

In fact, many are treating possible changes to the U.S. corporate tax code and the repatriation of overseas assets as a “fait accompli” in the medium term as both Republicans and Democrats search for common ground.

“If I were a chief financial officer (CFO), I would pencil that in three or four years my foreign tax rate would be 15 percent and that my domestic tax rate would be between 25 percent and 28 percent,” says University of Southern California Law Professor Edward Kleinbard. “In this kind of environment, that would be the best outcome for large, multinational firms.”Under current law, critics argue, U.S. corporate code encourages multinational firms to keep assets overseas since profits earned abroad are tax free as long as they are not brought back into the country. At the same time U.S.-based companies must pay the U.S. rate of 35 percent on all the income they earn, which many detractors consider high and punitive for companies with primarily domestic income.The current regime has caused an increasing number U.S. companies with overseas subsidiaries to keep assets parked in foreign jurisdictions. A study issued by the U.S. Public Interest Research Group (PIRG) in August said that 82 of the top 100 publicly traded companies (measured by revenue) maintain subsidiaries in offshore tax domiciles, representing $1.2 trillion in assets.Some of the largest U.S. companies — including American Express Co., Oracle Corp. and Apple Inc. — have the most significant overseas asset purses, with 15 companies accounting for nearly two-thirds of the offshore cash, PIRG said. In addition, reports in 2012 described Google Inc.’s “Double Irish” and “Dutch Sandwich” tax strategies that created convoluted mechanisms to maximize the foreign tax allowance.

But with congressional budget talks reaching a tipping point, money held overseas by U.S. companies is too much for revenue starved Washington to ignore, and the Obama Administration and Congress has been trying finding ways to bring that money back home.

In July, U.S. President Barak Obama said in a speech that he would support simplifying the corporate tax code with lower rates that included a one-time increase in revenue devoted to spending on manufacturing development, worker training and infrastructure improvements that create jobs.The jobs-related programs would be funded by a one-time “transition tax” targeting foreign earnings that U.S.-based companies currently hold overseas.

“I’m willing to work with Republicans on reforming our corporate tax code, as long as we use the money from transitioning to a simpler tax system for a significant investment in creating middle-class jobs,” the president said at a July 30, 2013 speech announcing the plan. “That’s the deal.”

It is not the first time the president has offered a tax reform proposal. In February of last year the administration proposed reducing the top corporate rate for most companies to 28 percent from 35 percent. The plan would change historic tax-code features like interest deductibility, as well as including more politically beneficial proposals, such as lowering the rate for manufacturers to 25 percent and expanding and making permanent the research-and-development (R&D) tax credit.Focus on corporate foreign tax practices is also coming from conservatives, including the powerful chairman of the House Ways and Means Committee Rep. Dave Camp (R-Mich.). Camp’s plan, first introduced in 2011 legislation, would require companies to pay a onetime 5.25 percent tax on all offshore funds, regardless of whether they are brought home and to create a “territorial,” but different, tax system. Camp plans to reintroduce the legislation later this year, according to published reports.Key to the debate between both sides is that Camp wants the changes to be “revenue neutral,” as opposed to President Obama’s plan on using the money to pay for a jobs program.Whether the Obama or Camp plans are molded into real legislative proposals, it’s unlikely that either will pass this year, says Robert Kramer, senior director, government affairs, in the Washington, D.C., office of Financial Executives International.

“The two bills will probably be marked up in the House Ways and Means and Senate Finance committees during the fall, at the earliest. I don’t believe they will be passed through both chambers by the end of the year, and it is even less likely that a conference committee will be appointed and have time to work out a compromise bill before Jan 1.”

USC’s Kleinbard is also pessimistic about legislation passing this year, pointing to revenue neutrality as the sticking point. “Sen. Harry Reid (D-Nev.) says that there is a fundamental disagreement between the parties whether tax reform should be revenue neutral or should raise additional revenue and that’s an unbridgeable gap,” he argues.”That’s not just a question of words or presentation, and there is no reason for it to be resolved this year.”

However, Kleinbard says, corporate tax reform and lowering rate from 35 percent is a “theme that resonates with both sides of the isle” and that legislators will be forced at some point to find a compromise.

“There is a consensus that the statutory rate is too high and we need to address that in some kind of reform,” Kleinbar says. “And that is where there is an opening.”

“If there is a compromise on revenues, then there would be an opportunity to pass a bill in the first part of next year, before election year politics overtook the Congressional agenda.” Kramer adds. “However, the Obama administration is not a supporter of a territorial tax system, so that portion of Chairman Camp’s proposal may not end up in the final bill — or it could end up being tempered by the administration’s proposal for a minimum tax on foreign income.”

If both sides can find common ground, it will be on the fact that changing the corporate tax code to repatriate assets is about “fairness.” A General Accounting Office (GAO) report issued in July says that “profitable” U.S. corporations paid an effective tax rate (ETR) amounting to about 13 percent on the pretax worldwide income (compared to 35 percent for U.S.-only firms) reported in financial statements issued 2010, which is the most recent date with information available.

“When foreign and state and local income taxes are included, the ETR for profitable filers increases to around 17 percent. The inclusion of unprofitable firms, which pay little if any tax, also raises the ETRs because the losses of unprofitable corporations greatly reduce the denominator of the measures,” the GAO report states. “Even with the inclusion of unprofitable filers, which increased the average worldwide ETR to 22.7 percent, all of the ETRs were well below the top statutory tax rate of 35 percent.”

Leveling the playing field between U.S. and foreign assets will also have the spillover effect of creating confidence in the personal income tax world, Kleinbard argued when he testified before the House Ways and Means Committee on the issue in June.“By being aggressive, some large multinational firms achieve tax results that they would not obtain if the energies available to the two sides of the argument were more evenly matched. This in turn has important repercussions for tax system design,” he said in testimony.“It means that a complex and highly fact-driven international corporate tax system invariably will lead to lower tax revenues than might be expected under more neutral terms of engagement, and it means that the corporate tax system in turn will have a negative spillover into personal tax collections, through a degradation of individuals’ confidence in the fairness of the tax system.”This means the argument that both conservatism and liberal can agree with is creating a revenue neutral corporate tax structure that shifts offshore focus.

That is not to say compromise will be easy.

“Republicans and the business community want to move to a territorial system, and the Senate and the White House want to get rid of deferral, which is the one policy that is a step towards territorially,” says Dan Mitchell, economist and senior fellow at the Cato Institute.

“Why do we have all this talk of reform where there is point of compromise? It’s not as though one person wants to go five miles and one person wants to go 15 miles and you compromise at 10 miles. They want to drive in different directions.”

Still, Kleinbard argues the revenue issue can be overcome. And he even knows who will pay for it.

“Revenue neutral would require the lower rate to be paid for. It strikes me as highly probable that in that process that those creating stateless income will see rate increase. It’s an inevitable conclusion,” he says.

So the question about corporate tax reform is perhaps not if, but when. But timing can be everything in politics.”If the issue of revenue neutrality is not dealt with, even if the Republicans win the Senate in 2014, I don’t see tax reform passing during the remainder of Obama’s term,” FEI’s Kramer says. “In the unlikely event that the Democrats win both houses in the mid-terms, I don’t believe the president will rank tax reform high on his list of priority legislation he would work to get passed to secure his legacy.

“In short, corporations should watch the unfolding of tax reform closely over the next three years, with cautious expectations,” he adds.

Private companies also have a stake in the game, although many questions need to be answered, says Mike Kenny, chief financial officer at Panduit Corp., and member of FEI’s Private Companies for Tax Fairness Coalition (PCTFC).“As currently proposed, territorial taxation of controlled foreign corporate (CFC) earnings would only apply to corporate taxpayers. Territorial taxation puts U.S. companies and their CFCs on equal footing with their international competitors and enables more efficient and effective redeployment of business capital.” Kenny says. “Territorial taxation effectively removes a tax consideration from the reinvestment and redeployment decision for CFC earnings.”USC’s Kleinbard adds that CFOs should not jump the gun on changing strategies, but history is against the offshore tax regime in the long term.“It would be foolish to unwind anything until we know what the new world order looks like. You don’t want to create any unintended consequences,” he explains. “But, really, the current law is a testimony to unintended consequences. I don’t think anybody sat down with current tax law looking to create a hostile environment for inbound investment and rewarding international expansion. The winner and loser were never considered.”