Corporate taxation for the layman, and why we need a "territorial" system

There has been a great deal of discussion about adopting a "territorial" corporate tax system, much of it jaw-droppingly ignorant. It seemed to us that it would be much in order to explain corporate taxation for the layman interested in the policy debate.

First, a couple of warnings. The topic is infinitely complicated, so we will generalize in ways that will irritate tax and accounting professionals, and probably get too basic for most people who took business classes in college. We are, however, undeterred!

The basics

There are many ways to organize a business, including as a proprietorship, a partnership, or a limited liability company. We do not tax any of these structures separately -- the owners pay personal income tax on their share of the business's profits -- but each has disadvantages that drive most larger businesses to become corporations. We tax most corporations as separate entities. (Many small businesses in the United States organize as "S" corporations, which are "pass through" entities like partnerships, which is why people who favor low personal income taxes talk about the impact of high rates on small businesses, but that controversy is not the subject of this post.)

In general, corporations in the United States pay federal corporate tax at the rate of 35%. They also pay state corporate tax at varying rates. This is all fairly straightforward for individual American corporations with no foreign subsidiaries.

Of course, most larger American corporations own and control other corporations, often because they wish to do business in a foreign country and it is advantageous or even required to form a local corporation to do so. For our purposes, let's call the top corporation (the one you would buy shares of stock in if you were to invest) the "ultimate parent," American subsidiaries "domestic subsidiaries," and non-American subsidiaries "foreign subsidiaries."

Of course, the foreign subsidiaries often earn profits in foreign countries which levy corporate tax on those profits. These rates can vary enormously, but they are almost all lower than the US federal rate, and lower still than the blended federal-state rate.

A bit about "headline" tax rates and the difference between tax and accounting

In the American system, we keep separate books for accounting (financial reporting) and tax purposes. This is because financial reporting and tax have different purposes. The purpose of financial reporting is to reflect the financial results and position of the corporation as fairly as possible. "Profit" for financial reporting purposes, however, may have little to do with profit for tax purposes, in part because there are provisions in the tax code intended to change behavior. So, for example, the Congress might decree that a machine expected to last 10 years can be "depreciated" (expensed) over three years for tax purposes so that businesses can get larger and faster tax deductions and will therefore have an incentive to buy machines more quickly. We still require that the machine be depreciated over 10 years for financial reporting purposes, because we want accounting to be true to the underlying economics regardless of the machinations of Congress.

The result is that "reported" and "cash" tax rates are often different for entirely legitimate reasons, usually required by law. Journalists, even such experts as the editors of the New York Times, rarely understand this difference or deliberately obscure it to rally their readers to some policy view. (If you are a confused financial journalist, here is a somewhat more involved summary of the differences between "book" and tax income under American law.)

Calculating taxes for a multi-national corporation: Transfer pricing

Before we get in to the differences between the American and "territorial" corporate tax systems, we need to understand how a multinational consolidated group (the ultimate parent and all its subsidiaries, domestic and foreign) determines what taxes to pay in which country.

The short version is that the corporation calculates the profits earned in each country by each subsidiary in that country, and pays taxes accordingly. In some cases, each subsidiary within a country pays taxes as if it were independent, and in other cases all the subsidiaries within a country pay taxes on a "consolidated" basis, meaning that losses in one subsidiary within that country can offset profits earned in another.

The challenge for governments everywhere is that multinational corporations will arrange their affairs to make a lot of profits in countries with low tax rates, and as little as possible in countries with high tax rates. So, for example, if a company manufactures in a low tax country and sells its products in a high tax country, it would (if left to its own devices) have the low-tax manufacturing subsidiary charge a very high intercompany "transfer" price to the high-tax selling subsidiary. The effect would be to build up profits in the low-tax rate country, and earn very little in the subsidiary that is actually selling the products.

Not surprisingly, governments everywhere, especially in high-tax countries, have cottoned on to the manipulation of transfer pricing. We now have a body of rules and practice that govern how international corporate groups price goods and services moving between subsidiaries across national borders. Generally, a multinational must document its non-tax business rationale for its transfer pricing by doing a "study" that justifies intersubsidiary transactions by considering whether they are comparable to "arms-length" prices charged and paid by unaffiliated businesses. The result is that profits among the subsidiaries in a consolidated group more or less land where they ought to land, at least in the abstract. (Transfer pricing and related international tax issues is a very complicated field and the subject of endless planning by multinational groups, but it is also an area of intense scrutiny by taxing authorities and auditors, so in the end the various locations of a given multinational's profits and taxes make objective sense, on average.)

However, even the most compliant transfer pricing cannot alter the basic fact that big differences in tax rates between jurisdictions will drive big differences in behavior over the long term (and tax-planning is one area where businesses manifestly plan with a far longer horizon than our federal government, even when the political class is competent). One small example: Analysis of transfer pricing tends to assign the most value to the location of intellectual property. Why? Because mere contract manufacturers do not make big profits in the real world. So if a multinational invents something in the United States and has it made in, say, Ireland (which has a 12.5% corporate tax rate), it cannot assign big profits to Ireland and therefore benefit disproportionately from the Emerald Isle's low rate. However, if it can arrange its affairs actually to develop products in Ireland, or (perhaps) at the behest of an Irish subsidiary, then it can assign much higher profits to the low Irish rate. That is an example of how the big disparity in the American corporate rate drives corporate planning that over the long term disadvantages the United States.

Comparing the American corporate tax system with the rest of the world's territorial approach

In virtually every other country, each corporation doing business in that country pays corporate taxes on profits earned in that country, but not on profits earned elsewhere (after taking in to account tweaks in transfer pricing and other items that might not survive an audit). This is called a "territorial" tax system.

The United States, virtually uniquely, taxes all the profits, regardless of location, of all the corporations in any multinational group for which the ultimate parent is domiciled (essentially headquartered) in the United States, and it does so at a 35% rate.

At this point, if you are still holding all this in your head, you are wondering at least three things. First, how is it that American multinationals do not face double-taxation, first on the profits they earn in, say, France, and then again on a consolidated basis? Second, why would any multinational in its right mind be domiciled in the United States? Third, why do so many multinationals report tax rates that are so much lower than 35%?

The double-taxation problem

American multinationals are not taxed twice on overseas profits because our system allows them to claim a credit for taxes paid to other countries. So, even though American multinationals owe tax to the United States for profits earned by their subsidiaries in France (to continue the example), the credit for paying taxes to France offsets much of that liability. (France has a 33% corporate tax rate, very close to the American 35%, so credits for French taxes paid offset most of the United States corporate tax on French profits. The disparity is much greater for other countries, including almost every European country.)

Why do multinationals domicile in the United States?

At this point, you can see that on its face the American system of corporate tax disadvantages multinationals domiciled in the United States. They confront a 35% tax rate in every country in the world, and that is almost always higher than businesses domiciled in any country with a territorial system, which is virtually all of them. Without some fix, holding all else equal US-domiciled corporations would earn a structurally lower rate of return, and therefore be at huge competitive disadvantage.

Fortunately, there is a "fix," of sorts. American corporations are allowed to "defer" the payment of taxes on profits earned overseas as long as they leave those profits overseas. So, for example, if an American multinational earns profits in the United Kingdom and pays tax there at that country's 24% rate, the payment of the remaining 11% owed to the United States can be deferred until the day that the American multinational repatriates those profits. In effect, the deferral mechanism is a kluge to put US-domiciled multinationals back on a level playing field. The price for this kluge is obvious: American companies can invest overseas profits subject to US deferred tax liability anywhere in the world other than the United States without incremental tax liability, but if they return those profits to our shores for some more valuable use here the right to defer tax vanishes immediately. The result is that American multinationals only repatriate profits earned elsewhere under unusual circumstances.

In effect, the deferral system, which is absolutely necessary to alleviate a huge structural disadvantage for US-domiciled multinationals, imposes a hefty import tax on capital that might otherwise go to build our economy.

Now, the aforementioned critics of a territorial system point out that when multinationals do bring back profits they do not necessarily create jobs here. True. That is because multinationals are almost always job-cutters by their nature. They are mature businesses with low growth rates and a strong propensity to acquire other companies that then have redundant overhead staff and so forth. But that thinking misses the point: If American multinationals repatriate their profits and simply (1) pay dividends to their mostly American stockholders, (2) buy back their own stock, or (3) buy American companies instead of foreign companies, that capital needs to be reinvested and therefore quickly finds its way in to the hands of actual growing businesses here.

It astounds me that otherwise intelligent people do not understand this basic point: If a mature company like Microsoft buys a venture-backed start-up, the venture capitalists who pocketed the proceeds then need to reinvest that money in new start-ups. Duh. Any American with two brain cells to rub together would prefer that mature American multinationals buy small companies in the United States instead of in other countries, yet our corporate tax law makes it much more advantageous to do the reverse.

But wait, there is even more disincentive for American multinationals to invest in the United States, this time from the accountants!

Why do American multinationals report tax rates that are so much lower than 35%?

In general, American accounting rules ("generally accepted accounting principles," or GAAP) require that companies book expenses when they are accrued, rather than when they are actually paid. So if my company buys some widgets from a vendor, we book an expense today, in the fourth quarter, even if we do not pay the vendor until January. Similarly, if we incur a tax liability today, we show it as an expense in the current period even if we actually pay the tax in the future.

The question under GAAP, however, is different if the incurred liability might never be paid, and this is where the interaction between accounting and the American corporate tax system gets tricky. Remember those "deferred" taxes on foreign profits that we allow so that American-domiciled multinationals are not at a structural disadvantage to foreign corporations? Well, GAAP says that you have to book those deferrals as a liability (which lowers your reported earnings per share, for instance) unless you declare that you have no intention to bring them back to the United States. In other words, if you swear on a stack of tax regulations that you are not going to repatriate the overseas profits subject to deferred tax liabilities, you do not have to book the deferred taxes under GAAP and you therefore have higher earnings than you would have if you planned to bring the money home notwithstanding the higher taxes.

But wait, it gets worse!

You might point out that there are lots of countries with tax rates quite close to ours -- France, for example, which at 33% is just two points lower than our 35%. Why not bring French profits home and eat the 2%, which is probably lower than one's cost of capital, and leave profits earned in the UK and Ireland outside for reinvestment elsewhere?

Good question. The answer is that the accountants will tell you that if you bring home the French profits and pay the deferreds you run the risk of impeaching your assertion that you plan to leave other foreign profits outside the United States. In other words, if an American corporation brings home the profits from high-tax countries (and for which there are small deferred taxes owed to the United States), they might have to book current liabilities for the big deferreds attributable to low-tax countries like Ireland and the UK. That would lower reported earnings per share, which is a bad thing. Not only are we corporate tools generally rewarded for producing higher earnings, our stockholders -- mostly Americans -- get really grumpy if we do not. Since American executives and stockholders are paid to produce higher earnings, under the current system we all have a strong interest in leaving overseas profits overseas. Good for us, bad for America, but all an extremely predictable consequence of our unique and dysfunctional corporate tax system.

Concluding thoughts

From my point of view, the United States is shooting its economy in the foot by doggedly clinging to its unique system of taxation. Not only does it put American multinationals at a competitive disadvantage (even taking in to account the right to defer taxes on foreign earnings), it creates a huge incentive for them to invest capital anywhere but here. If we do nothing else in the next few years, we should go to a territorial system.

There will, of course, be objections. Some of those objections are founded in ignorance. It is a complicated topic. Perhaps this post will help clear some of it up for the concerned citizen and journalist. Others oppose territorial taxation because they simply want to bash "corporations," or suspect that there is some trickery in the calls for reform. Such people are unlikely to change their mind. We note, for instance, that the American left is very fond of citing foreign law and opinion as authoritative on such issues as capital punishment and gun control, but loses its delight in global practices when corporate tax is at issue. We suspect the reason is not principled.

Finally, I am neither an accountant nor a tax expert, but a corporate lawyer evolved in to a chief financial officer of a public company. If I got any of this wrong, please straighten me out in the comments and I'll revise the post in due course. I wrote this in part to organize my own thinking on the topic, and corrections will only further that purpose.

Release the hounds. Or, better yet, send this to your Congressman.