Is Obama's Multinational Tax Squeeze Fair Play?

Obama's plan to bring home more revenue from multinationals is more complex than meets the eye
Obama's plan to overhaul how foreign income is taxed has caused an uproar Jim Watson/AFP/Getty Images

The verbal slugfest between the Obama Administration and American business leaders over new proposals that would raise taxes on profits earned abroad has framed a complex issue in simplistic ways. The Administration, resorting to starkly populist language, has all but labeled some global companies as tax evaders. Meanwhile, R. Bruce Josten, the top lobbyist for the U.S. Chamber of Commerce, accuses the President of hammering "companies struggling to compete in global markets."

Policy rumbles over taxes are never pretty, and this one threatens to increase costs by nearly $200 billion for U.S. corporations operating overseas. The Administration is proposing tougher rules for when profits generated abroad should be taxable in the U.S. It's also taking sharp aim at the common practice of shifting profits from foreign subsidiaries in countries with high tax rates to offshore tax havens (table). Another focus: tighter limits on the credits companies receive for the foreign taxes they pay, which offset what they owe on U.S. income. Obama's team thinks these new rules will curb incentives for companies to shift jobs overseas. Business lobbyists see the changes differently. "The bottom line is, they have proposed a tax increase of $190 billion on the overseas activities of U.S. multinationals," says Kenneth J. Kies, who has represented General Electric (GE), Microsoft, and others on tax issues.

Beware of spin-doctoring by both sides in this debate. For instance, in a May 4 speech announcing his tax plan, Obama chastised U.S. corporations for paying little more than 2% on foreign revenue to Uncle Sam. That works out to just $16 billion in taxes on the $700 billion they took in overseas in 2004. However, the White House neglects to mention the $120 billion American companies paid in foreign taxes that year.

There is no denying some huge distortions in the tax code. James W. Owens, chairman and CEO of construction-equipment maker Caterpillar (CAT), argues that the proposed changes will damage the ability of U.S. companies to compete overseas. "Do we want to have U.S.-based multinational companies that are leaders in the world?" he asks.

Yet that's a different issue from whether U.S. companies are accurately reporting where they generate profits overseas. According to a Brookings Institution study, some 30% of the profits earned by U.S. companies abroad come from the Netherlands, Ireland, and Bermuda--all low-tax regimes. However, none of those three nations is among the top 10 locations for U.S. multinational jobs. "In the end, this bill is aimed at getting rid of the aberrations in the way the tax code works," says Michael Ettlinger, the head of economic policy at the Center for American Progress, a liberal think tank.

Most of the corporate fury so far has focused on Obama's plan to limit the benefits companies get when they defer paying taxes on money earned abroad. Under current law, companies don't pay the 35% U.S. corporate rate unless they bring those profits home. As long as they keep the money abroad, they pay the lower rates in effect overseas. American companies say that break is critical, since their foreign rivals pay the lower local taxes.

But a senior Administration official says the tax deferrals wouldn't end altogether, as many had feared. Instead, the goal is to better align when a company can write off the expenses it incurs abroad with when it actually pays U.S. taxes on the profits it earns. Today, a U.S. multinational can immediately deduct those expenses, even if it indefinitely puts off U.S. taxes on the earnings. Under the President's plan, a company wouldn't get the deduction until the year it brought the money home and paid U.S. taxes. "They can't have it both ways," says the official.

Sounds reasonable. But it's a distinction without much meaning to many executives, since the result would be a higher tax bill on foreign profits kept abroad.

Avoiding such a financial hit is one reason disk-drive maker Seagate Technology (STX) incorporated in the Cayman Islands a few years ago, says former CEO William D. Watkins. He predicts many other Silicon Valley firms will follow Seagate's lead if the Administration continues its push. "Trust me, plenty of companies will do what we did," he says.

Such arguments have won some sympathy on Capitol Hill where Republicans are already planning to resist the Obama plan. But business may have a tougher time pushing back against the President's proposal to eliminate rules in effect since 1996 that allow companies to reduce their U.S. tax exposure through complex financing deals between subsidiaries in countries with high and low tax rates.

Say a company invests $10 million in a plant in Germany, a high-tax country. At the same time, it sets up a subsidiary in the tax haven Cayman Islands, which lends the $10 million at a 10% interest rate to the German unit. Now, the cost of that loan ($1 million in interest in this case) becomes a deductible expense in high-rate Germany. At the same time, the subsidiary that lent the money gets its $1 million in interest income taxed at a lower rate in the Caymans.

Normally, the interest received by the Cayman unit would be taxable in the U.S. But since the mid-1990s rule change, the income simply disappeared for U.S. tax purposes. Not surprisingly, such lending subsidiaries in tax havens have flourished--from a few hundred in late 1996 to nearly 8,000 as of 2000. Altering these tax rules could potentially have an even bigger impact on corporate bottom lines than deferral, allowing the U.S. government to recoup $86.5 billion in tax revenues between 2011 and 2019.

Similarly, Obama has proposed trimming companies' use of foreign tax credits to reduce their U.S. tax liabilities. Here, the Administration is targeting multinationals' ability to maximize the credits they get for foreign taxes paid by attributing all the overseas income they bring home to high-tax countries. If Obama's tax proposals become law, a company would have to average out the tax rates paid in the various overseas countries it operates in.

To win business support, the Administration has offered to use some $75 billion of the funds raised to make permanent a popular research and development tax credit. But many executives argue that any changes in overseas tax treatment should be part of an overall reform bill that would lower the 35% statutory rate. Though Obama has said he'd consider such a move, for now it's not on the table. That is a future battle with far bigger stakes.

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