The draft proposals issued by the heads of the President's deficit reduction panel call for scrapping the nation's current system for taxation of foreign income and replacing it with a territorial system — i.e., one in which income earned outside of U.S. borders is not taxed. I asked international tax expert Shawn Carson, director with accounting firm CBIZ MHM, for his take on the proposals.
BizTaxBuzz: Just how complex does the current “worldwide” system get?
Shawn Carson: The basic premise is simple: Foreign companies pay U.S. tax if, and only if, they do business in the U.S. or receive income from the United States. U.S. shareholders of foreign companies, including U.S. multinationals with foreign subsidiaries, pay tax when they receive a dividend from them. U.S. â€˜C' corporations get a credit for any foreign tax paid by a foreign company, but U.S. individuals, partnerships, LLCs, and S corporations don't.
It's the exceptions to the general rule that get complex. One main set of rules (contained in Subpart F of the tax code) taxes U.S. shareholders of foreign corporations on their share of income, whether the company pays a dividend or not. The Code takes 36 densely typed pages to explain these rules, and the tax regulations take another 279 dense pages to explain what the 36 pages are trying to say!
On top of that, you've got the IRS rulings and cases. Try a quick database search using Subpart F as the search term, and you'll find hundreds of documents under rulings or similar documents, and countless documents under tax cases. And this is just one set of rules among several.
Anecdotally — and this story is intended to be a criticism of the complexity of the tax code, not a criticism of the individual involved — we had a client that was being audited. The IRS agent tried to get assistance from his international colleagues, but the taxpayer wasn't a giant company, so they wouldn't help him! The agent did his best and suggested an audit adjustment, and we met with him to discuss why we thought the adjustment was inappropriate. I showed him the code section and the related regulations (for just one section of the code it was more than 200 densely typed pages). Needless to say, he gave the client a no-change on the issue.
BizTaxBuzz: It strikes me that, valuable as a territorial system might be to large companies, it's pretty much useless to the small businesses that we always hear described as the “engine of job growth.” Carson:
Carson:The benefit to small companies would be in the simplification to the tax code. At the moment, they have to comply with very complex rules that even IRS agents don't understand. This takes lots of time and money.
Smaller CPA firms also may not have the requisite international skills. A company came to see me because they felt that their current CPA firm didn't have enough international experience. On reviewing their tax returns, I found that the CPA firm had been filing the wrong form — never mind asking whether they'd filled it in correctly!
Going territorial would allow simplification so that small companies can focus on their business, not on form filling.
BizTaxBuzz: On balance, would a territorial system result in more jobs in the U.S or more jobs created abroad?
Carson: I'm not an economist, but based on my experience I don't think that it would make any difference. Businesses employ people here or abroad based on their business needs, local salary levels, government regulations, requisite skills. ... I can't think of any case where a client made a decision on where to employ a person based on territoriality. Territoriality could a make a difference as to which legal entity they used to employ the person, but not where they are employed.
The tax issue that does impact on job creation (in my experience) is marginal tax rates for employment taxes and income taxes. High marginal tax rates lead to lower employment.
BizTaxBuzz: Companies can already reduce their overseas tax rate by using the kind of strategies that Google got criticized for recently; doesn't this undermine the appeal of a territorial system?
Carson: There are three big-picture benefits of territorial tax system: First, companies can bring foreign profits back to the U.S. to invest, employ new workers, pay dividends, and so on. At the moment, cash is locked in foreign subsidiaries and can't be reinvested in the United States.
Second, U.S. multinationals would be able to compete on a level playing field with French, British, and German companies, and businesses from practically every other major country — they all tax on a territorial basis.
Third, the tax code would be simplified. Companies could spend less on compliance and focus on their businesses.
It's true that global tax rates are reduced by big companies that are aggressive and pay their tax advisers large fees. Small companies that, whether by error or design, don't follow the rules and are not effectively audited by the IRS may not care either. But everyone else has a huge compliance burden and pays, or risks paying, large amounts of U.S. tax on foreign income. If this is the system we want, then we have it! ###