Can bad get worse?

The Obama administration's new proposals would greatly alter international tax rules as they apply to U.S.-based organizations, which already pay one of the highest corporate tax rates in the world. FEI's Committee on Taxation is advocating--along with other business groups--for a fair and balanced tax code that would strengthen U.S. economic growth, increase job opportunities and improve the competitiveness of U.S.-based companies.

When United States Treasury Secretary Timothy Geithner announced the Obama administration's new tax proposals in May, corporate America cringed. As if the nation's businesses hadn't enough problems, the federal government was proposing new policies that would--in many cases--increase their taxes, weaken their competitive edge and add a new layer of complexity to calculations that were already excruciatingly complex.

Several of the most critiqued proposals would significantly alter the U.S. tax rules that relate to foreign-source income. Specifically, President Barack Obama's proposal would place significant limits on deferral.

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Current law allows companies to take immediate deductions for investments in foreign operations while deferring payment of taxes on the consequent profits until those funds are "repatriated" to the U.S.

The administration's proposal--which the president says aims to increase tax revenues by $281 billion over the next 10 years--would revise the rule on deductions by U.S. companies to the extent they are allocable to unrepatriated foreign earnings.

"It's a tax code that says you should pay lower taxes if you create a job in Bangalore, India, than if you create one in Buffalo, N.Y.," Obama said when he announced his proposed alternative.

Under Obama's proposal, the deductions for investment would be deferred as long as the taxes are. No repatriation, no deduction. The only exception would be for investments in research and experimentation.

The proposal would also correct what the administration refers to as "foreign tax-credit loopholes" in the current law by ending certain foreign tax credits. Current rules allow American companies that pay foreign taxes to claim a credit against their U.S. taxes, and the administration writes "some U.S. businesses use loopholes to artificially inflate or accelerate these credits." By closing those so-called loopholes, the administration hopes to reap some $43 billion between 2011 and 2019.

The proposal moves to fulfill Obama's campaign promise to eliminate a tax that is widely perceived--and many would say misperceived--as rewarding the exportation of jobs. If companies couldn't deduct their investments until they paid taxes on their profits, the argument goes, they'd be more likely to keep their operations--and jobs--in the U. S.

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On the surface, the argument has an air of fairness. A company that keeps all its operations in the U. S. has to pay the full 35 percent federal tax on its profits, and quite likely a state tax, too. A company that moves its operations overseas may pay a small fraction of that percentage, as long as it keeps reinvesting its profits offshore.

"These aren't loopholes," argued U.S. Chamber of Commerce Chief Economist Martin Regalia, in an article posted on May 4 on CNN-Money.com [referring to the administration's proposals]. "This is only about raising more money--it's not about making the tax code simpler or more efficient or easier or anything else."

Then, on May 21, Financial Executives International's Committee on Taxation sent a statement to Congress urging its members to "help U.S. businesses stay competitive."

"FEI's Committee on Taxation strongly believes that President Obama's tax proposals, as currently outlined in the context of high U.S. corporate tax rates, would be detrimental to U.S. companies' global competitiveness.

"It is clear that U.S. companies grow domestically and U.S. jobs and wages increase when U.S. companies succeed internationally.

"U.S. companies need a level playing field to succeed in international markets, and from the standpoint of multinational corporations, a fair and balanced tax code must strengthen U.S. economic growth, increase U.S. job opportunities and improve the competitiveness of U.S.-based companies in both U.S. and international markets.

"This committee of financial executives cannot support policies, such as deferral 'reform' that would make American companies less competitive in the world."

What Global Competitors Do

When American corporate tax executives crunch the numbers, they don't see anything fair about the argument that the current tax policy inspires them to invest overseas. The reason: They do business in a global economy in which their non-U.S. competitors pay lower taxes in their home countries and no taxes on their overseas operations (See table "Statutory Corporate Tax Rates for OECD Countries, 2008" on the next page.)

An article by Jesse Drucker in the April 22 edition of The Wall Street Journal, noted that "The likelihood of some change to the current law is generating intense opposition from companies that generate big earnings offshore. Two hundred companies organized by the Business Round-table wrote to congressional leaders last month to oppose the proposal."

Indeed, Ronald D. Dickel, vice president, tax, of giant aluminum-maker Alcoa Inc., and chair of Financial Executives International's Committee on Taxation (COT), warns that this isn't just a matter of a tax increase.

"This is the tax issue of our generation," says Dickel, who is a member of FEI's Pittsburgh Chapter. "It isn't just a simple revenue-raiser. I think it will fundamentally change global companies and how they can compete abroad."

As an example, he cites his company's experience in Iceland: "Alcoa built an aluminum smelter in Iceland, where the tax is 15 percent. We invested billions. We were there not for the tax benefit but because they have low-cost sustainable power--so-called 'stranded power,' because if it's not used, it goes to waste.

"President Obama's proposal would require Alcoa to pay 20 percent to its home country in addition to the 15 percent paid to Iceland. Other foreign companies would be paying only Iceland's 15 percent, thus making them more competitive. They're going to be able to make and deliver aluminum a lot cheaper than we are if this bill goes through."

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Further, under such conditions, Dickel says, fewer companies will open headquarters in the U. S. And those that have headquarters in the U. S. will have to move offshore to remain competitive.

And with them go the jobs that President Obama is trying to keep home.

Remy J. Farag, senior international tax analyst at the Tax & Accounting business of Thomson Reuters, is less sure that a migration of business or subsidiary operations is inevitable. "Nobody really knows what the long-term consequences of the president's proposed tax reform will be," he says.

"Business decisions very rarely come down to mere tax matters. The tax consequence of a given transaction is a small part of a much larger picture. There will definitely be other factors that a U.S. multinational will have to take into account before shifting production to or from the U.S., including appropriate business decisions, labor costs and intellectual property considerations," says Farag.

David P. Lewis, vice president-global taxes, chief tax executive and assistant treasurer at pharmaceuticals company Eli Lilly and Co., has an even more compelling reason to open operations overseas: That's where the customers are, he says. Lewis is a member of FEI's Indianapolis Chapter.

"Approximately 95 percent of the world's consumers are located outside the United States," says Lewis.

"Therefore, if U.S. companies cannot compete abroad because they are paying higher taxes, the U.S. economy will suffer, both from the loss of foreign markets and the loss of domestic jobs that support foreign operations ... I simply do not and will not understand how such tax increases will help strengthen U.S. companies and enable them to employ Americans, particularly at this critical juncture in our history."

Worldwide Versus Territorial Tax Regimes

Lewis's concerns with the link between taxes and competitiveness are well-founded. The U. S. not only has the world's second highest corporate tax rate (Japan's is higher), but it is virtually the only country that has a worldwide--as opposed to territorial--tax policy. American-based companies pay U.S. taxes on both domestic income and foreign income. A worldwide tax policy collects taxes on profits that American companies make anywhere in the world.

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The United Kingdom and Japan also have worldwide systems, but each is moving toward territorial systems that collect taxes only on operations in their own countries.

The American system for raising revenues is also the most complex system, and not only for the taxpayers but for the tax collectors as well. Calculating taxes involves complicated considerations of taxes paid in other countries, with difficult considerations of which foreign taxes would or would not have to be paid in the U.S. if the operations were there.

In effect, notes the FEI Committee on Taxation statement, "deferral permits both U.S.-owned and foreign-owned companies to pay the same tax rate on their overseas operations.

While the administration's proposal does not repeal deferral outright, it will have the effect of substantially eliminating the benefit of deferral and, as such, will undermine the leveling of the playing field that the current deferral regime produces," notes the statement.

Matthew M. Miller, FEI senior director, Government Affairs, says, "FEI advocates sound business policies and we are concerned with the impact some of Obama's proposals would have on the competitiveness of U.S.-based businesses."

Miller says he's concerned about the direction of the drift of the proposed policy and its probable effects.

"From the standpoint of multinational corporations, a fair and balanced tax code should strengthen U.S. economic growth, increase U.S. job opportunities and improve the competitiveness of U.S.-based companies in U.S. and international markets," Miller says.

"U.S. companies grow domestically and U.S. jobs and wages increase when U.S. companies succeed internationally."

In an article posted June 3 on Bloomberg.com, reporter Ryan J. Donmoyer quotes Microsoft Corp.'s Chief Executive Officer Steven Ballmer as saying the world's largest software company would move some employees offshore if Congress enacts the president's plans to impose higher taxes on U.S. companies' foreign profits.

"It makes U.S. jobs more expensive; we're better off taking lots of people and moving them out of the U.S. as opposed to keeping them inside the U.S.," said Ballmer.

In the same article, Ballmer estimated that higher taxes under the proposal would reduce profits for companies that comprise the Dow Jones Industrial Average by between 10 and 15 percentage points. "It's not a question of how much will the Dow come down," Ballmer said. "It's not about companies anyway; we're talking about shareholders."

Needed: Significant Tax Reform

Daniel N. Shaviro, Wayne Perry professor of Taxation at New York University and author of Decoding the U.S. Corporate Tax, sees a need for change.

He believes that with fundamental improvements a new tax regime could simplify compliance and make U.S. companies more competitive, while raising the same revenues that are raised now. The problem, he says, "isn't fairness but efficiency. The rules create enormous efficiency costs relative to the revenue they raise."

Shaviro would like to see the U. S. either eliminate deferred taxation, while lowering the tax rate, or switch to a territorial system in which investment abroad isn't taxable at home, but with a one-time transition tax on pre-enactment foreign-source earnings that were expected to be taxable.

He'd also like to see improvement in the rules for determining the source of income for U.S. and foreign companies alike, so they'll have a harder time recharacterizing U.S. source income as foreign-source income.

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Further, Shaviro points out that the distinction between U.S. and foreign companies is "pretty trivial ... since corporations don't really have a residence in the same sense as individuals."

When Obama and Geithner announced their plan in May, they wove the corporate tax proposal in with a parallel proposal that would take aim at overseas tax havens that help Americans hide money from their government.

They cited a Government Accountability Office report that found that of the 100 largest U.S. corporations, 83 had subsidiaries in tax havens. They also cited a single address in the Cayman Islands that is home to 18,857 corporations.

A report issued in May, 2009, by The Tax Foundation, Bank Secrecy, Tax Havens and International Tax Competition, which was authored by senior research fellow Robert Carroll, defends the importance of tax deferral and acknowledges the need to enforce tax laws and punish evaders. It warns, however, about confusing tax evasion with tax competition.

"As often happens in Washington, D.C., issues that are related or only slightly related can become rhetorically intertwined in the public's mind simply because they sound similar," the report states.

"Unfortunately, the recent debate over bank secrecy and so-called tax havens has become intertwined with the broader issue of global tax competition and America's standing relative to the tax rates imposed by other developed nations."

The confusion makes for messy politics, but it also ensures that at least part of Obama's effort to reform corporate taxation will make its way to law. Lawmakers on the left and right will have a hard time justifying a vote in favor of corporations and wealthy individuals holed up in post office boxes on Caribbean islands.

If put into law, the new policy would also eliminate "disappearing" offshore subsidiaries. Shady companies have used the so-called "check-the-box" rules, established during the Clinton administration, to shift revenue to nonoperational subsidiaries that subsequently dissolve, taking their tax obligations with them.

The new policy would also include a package of disclosure and enforcement measures that would induce foreign financial institutions to share information with the Internal Revenue Service; and it would increase penalties for failing to report overseas investments.

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Shaviro would like to see the whole world get its international tax act together. "Everyone's rules could stand to be modernized and improved," he says.

Nations that exempt outbound investment could generally do a better job preventing companies from recharacterizing domestic income as foreign source. This might require multilateral cooperation, for example, devising a uniform 'formulary apportionment' rules," adds Shaviro.

Here in the U.S., Congress, the White House and the business community will undoubtedly be debating this tax-deferral issue for many months to come, and an equitable answer will be hard to hammer out as economic, political, social and even emotional issues vie for attention. It promises to be a very interesting debate indeed.

This chart shows the 2008 U.S. combined federal state statutory corporate tax rate at 39.25%, which is second to Japan's 39.54%. This is from Tax Foundation Special Report, by Robert Carroll, senior research fellow, May 2009, Bank Secrecy, Tax Havens and International Tax Competition.

Statutory Corporate Tax Rates for OECD Countries, 2008
(Combined Central and Subnational)

OECD Country                            Statutory Corporate Tax Rate

Australia                                           30.00
Austria                                             25.00
Belgium                                             33.99
Canada                                              33.50
Czech republic                                      21.00

Denmark                                             25.00
Finland                                             26.00
France                                              34.43
Germany                                             30.18
Greece                                              25.00

Hungary                                             20.00
Iceland                                             15.00
Ireland                                             12.50
Italy                                               27.50
Japan                                               39.54

Korea                                               27.50
Luxembourg                                          30.38
Mexico                                              28.00
Netherlands                                         25.50
New Zealand                                         30.00

Norway                                              28.00
Poland                                              19.00
Portugal                                            26.50
Slovak Republic                                     19.00
Spain                                               30.00

Sweden                                              28.00
Switzerland                                         21.27
Turkey                                              20.00
United Kingdom                                      28.00
United States                                       39.25

G-7 Weighted Average (Excluding U.S.)               33.84
OECD Weighted Average (Excluding U.S.)              31.31

Source: Organisation for Economic Co-operation and Development
(www.oecd.org).

GLENN A. CHENEY (glenncheney@@comcast.net) is a Hanover, Conn., freelance writer who focuses on subjects pertaining to finance, business, accounting and financial reporting.