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Rethinking International Tax Reform

October 3, 2014 7 minute Read by Christopher Hanna

The press has been reporting on a number of corporate inversions, with one of the most recent being Illinois-based AbbVie Inc.’s $54.8 billion acquisition of Irish-based Shire PLC and subsequent inversion to the United Kingdom.  As a result of the wave of corporate inversions, the Obama administration and members of Congress have proposed various approaches to stem the tide.  One approach, that all sides seem to agree on, is that the United States needs to reform its corporate and international tax system.

The United States employs what is commonly referred to as a worldwide tax system with deferral.  Under U.S. tax law, a U.S. multinational is taxed by the United States on the earnings of its foreign subsidiaries when the earnings are repatriated typically by way of a dividend.

So if a U.S. multinational does not repatriate the earnings of its foreign subsidiaries, then no U.S. tax is imposed on those earnings.  This creates a lock-out effect in which the foreign earnings are locked out of the United States because the U.S. multinational does not want to pay U.S. tax on those earnings.

Most countries of the world employ what is commonly referred to as a territorial tax system.  In fact, 28 of the 34 OECD countries utilize such an approach.  Under a territorial tax system, a country taxes its multinationals only on income earned in that country.  Income that a multinational earns outside of its home country is either not taxed or is lightly taxed by the home country.

For years, tax scholars have debated whether the U.S. international tax regime should be modeled on the principle of capital export neutrality or capital import neutrality.  Capital export neutrality occurs when the tax burden on capital owned by residents of a particular country is the same whether that capital is invested at home or abroad.

If capital export neutrality is satisfied, the tax system neither encourages nor discourages capital export, and the residents’ choice to invest at home or abroad is not influenced by tax considerations.  Capital export neutrality has generally been associated with worldwide taxation coupled with a credit for foreign income taxes.  Generally, the United States’ international tax system is modeled along the lines of capital export neutrality.

In contrast, the theory of capital import neutrality holds that the international tax system should have equal tax treatment for all capital invested within a particular country regardless of the residence of the investor.  Capital import neutrality has generally been associated with territoriality – the idea that a particular country, as a general rule, should only tax income earned within its borders.  Generally, most countries’ international tax systems are modeled along the lines of capital import neutrality.

Unfortunately, the debate between capital export neutrality and capital import neutrality leads nowhere as scholars are usually hardened in their position.  More recently, however, several tax scholars have introduced the theory of capital ownership neutrality, the goal of which is to have tax rules that do not distort ownership patterns.

Capital ownership neutrality requires a U.S. multinational to be as competitive as any other bidder in pursuing a foreign acquisition.  In a world in which other countries have territorial tax systems, this can only be achieved if the U.S. moves to a territorial tax system.  If, however, the other countries shift to a worldwide tax system, then the United States would achieve capital ownership neutrality by adopting a worldwide tax system.

A number of business leaders have picked up on the concept of capital ownership neutrality, possibly without knowing it, in arguing that U.S. corporations are at a competitive disadvantage relative to foreign corporations based in countries with a territorial tax system.  For example, Andrew F. Puzder, CEO of CKE Restaurants (Carl’s Jr. and Hardee’s) recently wrote:

“The principal difference between a foreign- and U.S.-domiciled company is that U.S. companies have to pay an additional tax on foreign earnings when they repatriate (invest) those earnings back in the U.S. That tax is the difference between the lower tax rates they pay in the country in which they generate such earnings and the 35-percent U.S. corporate-tax rate (the world's highest) plus various state corporate income taxes. In other words, U.S.-domiciled companies are taxed twice (thrice including state taxes) on the same income while foreign domiciled companies are taxed only once — and at a lower rate.”

Walter Galvin, former vice-chairman of Emerson Electric, recently wrote in the Wall Street Journal:

“As with the relatively high corporate tax rate, America's world-wide system of taxation hinders growth, encourages companies to relocate outside of the U.S., makes U.S.-based companies vulnerable to foreign takeover, and puts American businesses at a competitive disadvantage internationally.”

Also, in the Wall Street Journal, Miles D. White, chairman and CEO of Abbott Laboratories, recently noted:

“The U.S. is among only a handful of countries, and the only one in the Group of Seven, that taxes companies on world-wide earnings rather than the earnings in their home domiciles. It's a double whammy: the highest rate, by far, and it's applied worldwide.

“In terms of global competitiveness, the U.S. and U.S. companies are at a substantial disadvantage to foreign companies. Taxes are a business cost. Our disproportionately higher tax rate puts foreign companies at a huge advantage competitively, and their lower tax burden amounts to a subsidy that encourages them to acquire American businesses.”

These business leaders are noting the disadvantage U.S. companies face against foreign corporations based in a country with a territorial tax system.  One or more of these business leaders could probably have given some anecdotal evidence of attempts to purchase a foreign company but losing out to a foreign competitor that was based in a country with a territorial tax system.

Christopher Hanna is a Bush Institute fellow and the Alan D. Feld Endowed Professor of Law and Altshuler Distinguished Teaching Professor at SMU’s Dedman School of Law.


Author

Christopher Hanna
Christopher Hanna

Christopher H. Hanna is a professor of law and a University Distinguished Teaching Professor at Southern Methodist University. Professor Hanna has been a visiting professor at the University of Texas School of Law, the University of Florida College of Law, the University of Tokyo School of Law and a visiting scholar at the Harvard Law School and the Japanese Ministry of Finance. In 1998, Professor Hanna served as a consultant in residence to the Organisation for Economic Co-operation and Development (OECD) in Paris. From June 2000 until April 2001, he assisted the U.S. Joint Committee on Taxation in its complexity study of the U.S. tax system and, from May 2002 until February 2003, he assisted the Joint Committee in its study of Enron, and upon completion of the study, continued to serve as a consultant to the Joint Committee on tax legislation.

Prior to coming to SMU, Professor Hanna was a tax attorney with the Washington, D.C. law firm of Steptoe & Johnson. His primary duties included tax planning for partnerships and corporations on both a domestic and international level and also tax controversy. He has received the Dr. Don M. Smart Teaching Award for excellence in teaching at SMU Dedman School of Law on eight separate occasions. In 1995, he was selected and featured in Barrister magazine, a publication of the ABA Young Lawyers' Division, as one of “21 Young Lawyers Leading Us Into the 21st Century” (Special Profile Issue 1995).

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