Before tax reform (the “Tax Cuts and Jobs Act” (TCJA)), the United States employed a worldwide system of taxation, which was antiquated and uncompetitive. American companies were taxed here on their U.S. profits, taxed abroad on their foreign profits, and then taxed again when those foreign profits were brought back home. Thus, their foreign earnings risked double taxation.
In contrast, virtually all foreign countries employed a territorial system of taxation – foreign companies paid taxes on their home country profits in their home country, and on their foreign profits in the foreign country, but those foreign profits were not taxed a second time when they were brought home. Thus, the double taxation of foreign profits was avoided.
To offset the advantage of a territorial tax system and help level the playing field between American companies and their foreign competitors, the U.S. employed a system of tax credits and tax deferral. Deferral allowed American companies to delay paying that second layer of tax on foreign earnings until that income was repatriated. While deferral was a necessary mechanism to mitigate the double taxation faced by American companies operating globally, concerns arose that in some instances, deferral allowed companies to delay tax on overseas earnings indefinitely, thus eroding the U.S. tax base.
What did we get?
Recognizing the many shortcomings of the U.S. international tax system, the TCJA overhauled many aspects of this system, seeking to improve American competitiveness while protecting the U.S. tax base. So, what did we get? First, the TCJA moved the U.S. tax system more towards the territorial systems employed by foreign countries, but not quite all the way there. Second, the TCJA also created two new categories of income to encourage operations in the United States and discourage earning intangible income through a foreign subsidiary; the interaction of these is often explained as a “carrot and stick” approach.
The carrot? Foreign-Derived Intangible Income (FDII), a provision whose pronunciation sparked much debate post-TCJA and that incentivizes American C Corporations to develop and retain intellectual property (IP) (and the associated revenue streams) in the United States. Under FDII, income that is deemed (under a rather complex formula) to be generated from using foreign intangibles enjoys a reduced tax rate of 13.125%. FYI, I’m in the “Fiddy” pronunciation camp – it’s fairly obvious that tax writers intended to incorporate a reference to a rapper in the tax code.
The stick? Global Intangible Low Taxed Income (GILTI), which seeks to reduce the incentive to shift profits outside the United States using IP. Absent GILTI, foreign intangible income earned through a foreign subsidiary would not be currently taxable in the United States. GILTI provides a deemed income inclusion that makes this income currently taxable; American companies can deduct 50% of GILTI, and the remaining amount is taxed at the 21% corporate rate; thus, GILTI is taxed at an effective rate of 10.5%. Trouble keeping the carrot and the stick straight? Just remember, your income, much like every defendant to ever appear in court, wants to be “not GILTI.”
Goal:
In the Macroeconomic Analysis of the TCJA, the Joint Committee on Taxation (JCT) stated that, “The proposals affecting taxation of foreign activity are expected to reduce the incentives for this “profit-shifting” activity, thus resulting in an increase in the U.S. tax base.” Kimberly Clausing, President Biden’s Deputy Assistant Secretary for Tax Analysis in Treasury’s Office for Tax Policy, has noted that “TCJA should be commended for providing some limits on tax avoidance through the GILTI and the BEAT [not discussed here],” and estimated that the new rules will result in a 20% decrease in profit shifting.
How it’s going…
In a recent article examining trends in U.S. cross-border M&A transactions post-TCJA, the author examined the 2018-2019 increase in cross-border mergers and acquisitions, saying that “while a range of factors likely affects the volume of outbound and inbound M&A in any year, the data support the notion that the 2017 tax reform legislation improved the attractiveness of the United States as the tax domicile for multinational enterprises.”
Likewise, the most recent data on U.S. multinational activities for the first year after the TCJA, indicates that the TCJA contributed to faster growth at U.S. parent companies for things such as employment and expenditures for property, plant, and equipment (PP&E) and research and development (R&D). This reverses a long-term trend where growth at foreign affiliates outpaced that of U.S. parents.
In other words, tax reform is working.
Some observations…
The mere existence of GILTI shifts the U.S. tax system away from the territorial systems of our foreign competitors.
Since, as noted by Treasury Secretary Janet Yellen in her Senate Finance QFRs, “most other headquarters’ jurisdictions impose no tax on the foreign earnings of their domestically-headquartered multinationals” GILTI is actually part of our current tax code that remains an anomaly compared to other foreign countries and pushes us away from a pure territorial system.
As a note, the OECD continues work on addressing tax challenges arising from the digitalization of the economy, which includes discussions around a global minimum tax, but the OECD Secretariat has clearly stated that such rules “would be more permissive than GILTI,” for instance, considering carryforward of losses and taxes and a lower rate than GILTI.
Let me translate that – even if the OECD were to succeed in adopting a global minimum tax, it would be less onerous than GILTI.
Some recent proposals suggest that we should raise the GILTI tax rate and/or change how GILTI is calculated by shifting from a global approach to a country-by-country approach. To preserve the competitiveness of American companies, it is imperative that we prevent these uncompetitive changes to GILTI.
The intent of GILTI was evident from the start of the tax reform process, when the Unified Framework clearly stated:
To prevent companies from shifting profits to tax havens, the framework includes rules to protect the U.S. tax base by taxing at a reduced rate and on a global basis the foreign profits of U.S. multinational corporations. The committees will incorporate rules to level the playing field between U.S.-headquartered parent companies and foreign-headquartered parent companies.
GILTI works effectively as a global minimum tax to deter profit shifting overseas. An increased GILTI tax rate would reduce American companies’ competitiveness versus foreign companies.
Through 2025, the effective GILTI tax rate is 10.5%, half of the 21% corporate tax rate, ensuring overseas profits are subject to U.S. taxation, but not at a rate so high as to bring back as much of a competitive disadvantage as American companies faced before the TCJA. The decision to tax GILTI at half the corporate tax rate was well considered. In contemplating the appropriate rate for GILTI, the Senate Budget Committee stated that it “recognizes that taxing that income at the full U.S. corporate tax rate may hurt the competitive position of U.S. corporations relative to their foreign counterparts, and has decided to tax that income at a reduced rate (with a portion of foreign tax credits available to offset U.S. tax).”
Calculating GILTI on an aggregate (or global) basis helps balance base erosion concerns with the need to level the playing field.
Policymakers intentionally choose to employ an aggregate calculation for GILTI, recognizing that because of the “integrated nature of modern supply chains,” “it is more appropriate to look at a multinational enterprise’s foreign operations on an aggregate basis, rather than by entity or by country.” Further, GILTI prevents base erosion and by using a global approach, does so in a preferred manner that minimizes the risk of double taxation while lessening compliance and administrative burdens.
The bottom line? Tax reform improved the competitiveness of our tax system by leaps and bounds, but certain aspects of the revised code still are very different from those of other foreign countries; our system remains moored somewhere in between worldwide and territorial. And proposals to double the GILTI rate or move to country-by-country calculation are simply a big step in the wrong direction.