Taxes 101: A Comparative PerspectiveMatthew Caminiti and Paul Hughes
When U.S. corporations earn profits from their overseas subsidiaries, they can either bring the income back home or keep it invested overseas. Most developed countries use one of two systems to tax such profits: worldwide or territorial. Here are the basics of each and examples of countries that use them.
Countries: U.S., Mexico, South Korea
How it works:
• Under the U.S. variant of the system, all profits are taxed at the home country's rate, regardless of where they are earned.
• A company can claim a foreign tax credit for taxes paid to other governments.
• Corporations may defer home country tax on active foreign earned income until that income is repatriated.
• Passive income, or profits earned from so-called intangible sources such as interest, is taxed in the U.S. as it is earned, regardless of whether it is repatriated.
Companies face the same tax rate on domestic and international income.
• Deferral provides an incentive for companies to reinvest their profits overseas to avoid the higher U.S. tax rate.
• U.S. companies pay higher taxes than their foreign rivals when they compete abroad.
Countries: Germany, U.K., Japan
How it works:
• A company is allowed an exemption for income repatriated from foreign subsidiaries. The exemption essentially allows overseas profits to be untaxed and immediately brought home.
• Some countries, such as Japan and Germany, exempt only 95 percent of repatriated profits.
• Eliminating tax on repatriated income encourages companies to bring profits back home. This may spur investment and create jobs.
• Governments do not have to track how much tax was paid to other countries, since there is no need for a foreign tax credit.
• Exempting repatriated profits from tax may lower government revenues, as companies have an incentive to shift operations and income to countries with low tax rates.
• Countries must determine how to allow companies to deduct business expenses—either against domestic income, overseas income, or both.
WHERE CASH TAKES A HOLIDAY
Congress in 2004 passed a law that allowed most profits repatriated to the U.S. to be taxed at 5.25 percent instead of 35 percent for a temporary tax holiday. Companies have used accounting techniques to shift their offshore profits to countries with low corporate tax rates—or none at all. Here are some of their favorite locales.
2006 GDP (2006 U.S. dollars) - $5.4 billion
Untaxed profits (2006 IRS data) - $51.1 billion
Bermuda's zero percent tax rate encourages U.S. businesses to set up holding companies in the country.
2006 GDP (2006 U.S. dollars) - $677.7 billion
Untaxed profits (2006 IRS data) - $42.0 billion
A "Dutch sandwich" transaction allows companies to route business transactions through subsidiaries and holding companies in Ireland, Bermuda, and the Netherlands to avoid income tax.
2006 GDP (2006 U.S. dollars) - $221.7 billion
Untaxed profits (2006 IRS data) - $37.6 billion
Using a "double-Irish" transaction, a U.S. company can route its intellectual property sales through an operation in Ireland and another in a tax haven. That allows firms to circumvent any tax on the intellectual property.
2006 GDP (2006 U.S. dollars) - $2.3 billion
Untaxed profits (2006 IRS data) - $28.1 billion
Ugland House in the Cayman Islands is the registered address for 18,957 companies. The Caymans' zero percent tax rate encourages U.S. businesses to establish holding companies there.
Sources: World Bank; Federal Reserve; IRS; U.S. Government Accountability Office