Under the current U.S. tax rules, non-U.S. earnings are generally not subject to U.S. tax until the earnings are repatriated. While the U.S. tax system generally taxes income of U.S. taxpayers wherever earned, profits earned from active overseas businesses, as opposed to passive overseas investments, are generally not taxed until those profits are repatriated to the United States. Multinational corporations can therefore legally avoid U.S. taxes on foreign business operations by leaving the profits overseas and reinvesting them.
The U.S. tax system therefore encourages U.S. companies to generate profits from active businesses in low-tax jurisdictions and retain the profits there rather than to generate profits from active businesses in the United States. To help enforce this system, the tax code has transfer pricing rules to help prevent U.S. companies from improperly shifting profits from U.S. business activities to overseas activities through manipulation of the prices charged on intercompany transactions.
Many feel, however, that the U.S. transfer pricing regime has not been successful in limiting the ability of U.S. multinationals to shift profits overseas. Some have characterized it as a problem approaching a trillion dollars in size.
The American Jobs Creation Act of 2004 provided a temporary tax holiday on repatriated earnings, taxing them effectively at 5.25 percent rather than 35 percent. While the provision was successful in getting U.S. multinationals to repatriate earnings at the favorable rate, a principal goal of the legislative provision, that the repatriated earnings be used for U.S. job creation, seems to have been less successfully accomplished. Repatriated earnings that were used for debt reduction or acquisitions may have created no U.S. jobs or even reduced U.S. jobs through efficiencies achieved from acquisitions.
One solution to the problem would be to try to make the transfer pricing regime work. Yet, the United States already has one of the most sophisticated transfer pricing programs in the world. Given the complexities of multinational operations, the role of intangible as well as tangible property in pricing, and the use of facilities in multiple jurisdictions to assemble a particular product, it is not clear that throwing a lot more money at transfer pricing enforcement can improve the result.
Another approach to the problem would be to eliminate the ability to defer taxes on profits overseas. To address concerns that eliminating deferral would make U.S. multinationals less competitive with their international counterparts, the Obama Administration has also hinted that “loophole closers” might be accompanied by a reduction in U.S. corporate tax rates. See President Obama’s 2014 Budget Proposal that includes a vast array of provisions related to International Tax and tax deferred income from foreign subsidiaries.
While some are still advocating a reduction in the tax on repatriated earnings as a solution, the lack of job creation resulting from that effort is likely to keep the Administration from pursuing a similar path.
Another related issue to the earnings of controlled foreign owned subsidiaries is that although generally, the earnings of a foreign subsidiary of a U.S. corporation (or a U.S. citizen, partnership, trust, etc.) is not subjected to the current U.S. tax on its foreign source income unless that income is repatriated to the U.S., it can also be subject to U.S. tax within the range of what the tax law calls “Subpart F income.” Included in Subpart F income is nearly every type of passive investment income and favorable pricing in transactions with related or affiliated U.S. entities or persons.
See future Blog Post for a continued discussion on Subpart F Income.