This summer offered some nice distractions that diverted our attention from other events — perhaps for the better. Now it is time to get back to reality.
My reality is often drawn to taxes and politics, given that I deal with taxes in my daily job. Politics impacts tax legislation. And that mix often results in fiscal and economic policy that isn’t always best matched to what the country needs.
We recall the media hype and political grandstanding two years ago when Apple CEO Tim Cook testified before the Senate Permanent Subcommittee on Investigations on Apple’s corporate tax planning. Committee Chairman Carl Levin and many of his colleagues attempted to paint Apple in a very negative light. Roll the clock forward two years to the change in control of the U.S. Senate, and there was a totally different tone at the July 30 hearing of the same committee, now under the leadership of Chairman Robert Portman.
This time around the discussion focused on the impact of the U.S. tax code on corporate mergers and acquisitions and U.S. jobs. The testimony provided by five business leaders provided insight as to how the corporate sector views the U.S. tax code and its impact on decisions made for merger-and-acquisition transactions and U.S. jobs.
I had the opportunity to watch and listen to some of the hearing on the Internet. I also had the benefit of reading the written documents submitted in advance of the hearing.
The message was not surprising. The witnesses discussed whether the U.S. tax code impacts decisions of U.S. companies and their foreign competitors. Some of the uncompetitive provisions of the U.S. tax code were discussed candidly by business leaders and Senate subcommittee members.
Three of those provisions struck home to me.
First, the high corporate income tax rate in the U.S.
This is, of course, no surprise to most. The federal rate is 35 percent plus state rates that push the U.S. corporate effective tax rate up to 40 percent. The U.S. rate is the highest among the Organization for Economic Cooperation and Development nations as reported in a March 2015 Joint Committee on Taxation report to Congress.
Compare the U.S. rate of corporate income tax to the United Kingdom, which is currently at a 20 percent corporate income tax rate. The U.K. announced in early July that the corporate income tax rate will drop to 19 percent in 2017 and 18 percent in 2020.
Second, the U.S. taxation of foreign earnings when they are repatriated to their home country.
Most of our trading partners have adopted a territorial or participation exemption approach where active business income is taxed only where it is earned and little or no tax is assessed when repatriated back to the home country. The U.S., on the other hand, has a worldwide taxation and credit system under which all income is taxed when received by a U.S. corporation, and a credit is allowed for any foreign income tax paid on that income.
Since the U.S. is the high-tax country, the current method of taxation of these foreign earnings results in additional corporate income tax being assessed on the earnings when they are paid to the U.S. parent company. This additional level of taxation is, in part, a large reason why we are reminded on a regular basis that nearly $2 trillion of foreign earnings of U.S. public companies has not been repatriated to the U.S.
Third, the U.S. rules on thin capitalization and interest deductions.
Most trading partners have limits on the amount of debt that can be borrowed from a foreign parent company. In Canada, this debt to equity ratio is 1.5 to 1.0. The U.S. doesn’t have such a strict ratio. The U.S. has a limitation on the amount of interest deduction as a percentage of adjusted company cash flow that can be paid to the foreign parent. This limitation is 50 percent, whereas in Germany, with a similar mechanism, the limitation is 30 percent.
The result of these U.S. rules is that many foreign parent companies leverage up U.S. subsidiaries with debt and strip the earnings out of U.S. taxable profits as interest deductions. That interest is taxed at a lower rate in the foreign parent jurisdiction, or perhaps not taxed at all if certain finance structures are utilized. In addition, some foreign countries have a limitation on the rate of interest that can be charged on intercompany debt. The U.S. has no strict limit and allows a market rate of interest to be charged.
These factors and others allow foreign companies to gain an edge in terms of how they structure merger-and-acquisition transactions and enhance the after-tax rate of return on such transactions.
One of the business leaders at the Senate hearing provided specific examples of how his company lost acquisition opportunities because, as a U.S. acquirer, it often cannot match the after-tax rate of return a foreign acquirer can obtain. This rate of return allows a foreign bidder to offer a higher transaction price to purchase a U.S. target.
This built-in bias in the U.S. tax code against U.S. companies may account for the large volume of foreign acquirers of U.S. companies in recent years.
As a result of these unfavorable tax code provisions, many U.S. companies have considered the widely reported inversion path to better position their tax profile in competing against their international competitors. We can just rewind to last summer when it seemed like inversions were the seasonal specialty on the tax-planning menu.
The one thing I took away from the hearing was there is recognition and appreciation among many lawmakers that corporate tax reform needs to consider how to make the U.S. tax code more competitive and, and at the same time, achieve desired fiscal and economic benefits to the country.
Now, the difficult part: how to pass legislation and obtain presidential signature on any tax changes involving corporate tax reform.
Albert Einstein once said insanity is doing the same thing over and over and expecting a different result. Perhaps those in Washington will consider doing things differently when dealing with corporate tax competition and the U.S. tax code.
Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author and not necessarily of BDO. The comments are not to be considered specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult their professional advisers before acting on any items discussed.