Foreign earnings, domestic loopholes

I hate it when seemingly obvious problems persist, even when they could be resolved quickly and easily. I come to this issue in consideration of international taxation rules and allowances. Bear with me…

As a general rule, companies pay income (or corporate) taxes in the country in which the income is sourced. US companies making money in the US pay taxes to the US treasury; British companies making money in Britain pay to the British treasury; etc. Now suppose we have a US company with a British subsidiary. Britain would have a claim on the profits earned by the subsidiary, which leads to the concern of taxation by both authorities, or double taxation.

In cases when income derives from sources in different countries, double taxation could be an issue. For example, suppose the tax rate in the US is 20 percent and the tax rate in the foreign country is 15 percent. Assume the foreign subsidiary generates $1,000,000 of income for the benefit of a US taxpayer. Without any accommodation, the foreign treasury would look to collect $150,000 and the US authorities would want $200,000 — a case of double taxation.

US tax treatment and bilateral tax treaties mitigate this problem by providing a tax credit for the taxes paid to foreign authorities. The subsidiary still pays $150,000 to the foreign treasury. At the same time, the US treasury still charges $200,000, but it grants a $150,000 credit for the foreign tax payment. Thus, the US government ends up collecting only $50,000 (= $200,000 — $150,000). As long as the tax rate abroad is lower than that of the US, the US government would collect something. On the other hand, if the foreign tax rate were greater than or equal to the US tax rate, the US government would end up with zero revenues.

Generally, the two parties to a bilateral tax agreement accommodate to this prospective outcome of possibly realizing no tax revenues because the treatment is reciprocal. That is, while instances may arise where the lion’s share of the tax revenues go to one country, presumably those instances would be offset by other situations where the division of tax receipts work the other way.

While zero or low taxes abroad might provide an incentive for companies to manage their operations from those low-tax areas, thereby escaping the higher US taxes, this benefit only arises because, under current US law, that income is exempted from being taxable in the US. It shouldn’t be. Irrespective of whether that income is repatriated or not, it’s generated to the benefit of the US owners of the company; and therefore, by rights, it should be taxable to the US taxpayer. Such a treatment would put a nail in the coffin of tax havens altogether and make any associated tax avoidance schemes moot. Again, having this income subject to US taxation should allow for applying tax credit for the taxes paid to the foreign entity in order to eliminate double taxation.

So why doesn’t it work that way? Why do some venues continue to serve as tax havens allowing some of our biggest US-domiciled companies to avoid paying US taxes on significant amounts of earned income? The answer is clear: too many loopholes. Too much income that should be taxable to US taxpayers is exempted or otherwise subject to reduced tax rates by law. Realized income, from whatever source, should be subject to US taxation without preference, allowing for any appropriate tax credits for taxes paid to foreign governments.

The starting point for reform is for Congress to revise the rules defining taxable income for US taxpayers. Given the magnitude of budget deficits projected into the foreseeable future, you’d think that Congress would see the revenue captured by such an effort as low hanging fruit — an obvious source of revenue that could easily be harvested. Doing so, however, would necessarily mean countering the efforts of the special interests bent on preserving the status quo — perhaps a heavier lift than it may first appear.