US Taxation of Multinational Enterprise: Part V

Thank you all for the posts. Compare Jim's comments on Part III to Paul's on Part IV and you get the contours of the contemporary debate. Dan's, PGL's, and Jim's posts flesh out how complicated these issues are in the real world. (Jim, I really hope that Michael takes the blog back over before I have to talk about consumption taxes.) In the end, I do not have a view on the deduct vs. credit issue with regard to foreign taxes, because I do not understand the welfare effects of international trade adequately at this time. But, I can focus the analysis so that others can apply their views of trade.

Which gets us back to the foreign tax credit.

The discussion thus far has dealt with foreign taxes at a rate below the US rate. Sue's European taxes, however, are at 50%, which is above the US rate. For simplicity, assume that the US rate is 35%. Even if one accepts a credit for foreign taxes, giving a full credit when the foreign rate exceeds the US rate can be troubling. The US not only would be forbearing from taxing the foreign income but would be paying Sue's extra 15% foreign tax. This seems wrong, even if in the best interests of trade. Also, the extra 15% may pay for extra benefits in the foreign country, so that a deduction, not a credit, is appropriate.

The US has dealt with high foreign rates with a limit on the amount of the total credit for foreign taxes equal to total foreign income multiplied by the US tax rate.

Unfortunately, this creates a new set of problems: Sue's foreign taxes are $1 million. Her US tax credit limit is 35% (the US rate) of the $3 million of foreign income, $1,050,000. Since this exceeds her $1 million of foreign tax, so all of Sue's foreign taxes are creditable. Thus, while her foreign income generates $1,050,000 of pre-credit US tax (35% of $3 million), she is allowed a $1 million credit, and her foreign income bears only $50,000 of net US tax. In other words, her $1 million of low-tax foreign income bears only $50,000 of net US tax because of the way that the current US foreign tax credit works.

The phenomenon discussed in the preceding paragraph is referred to as the “averaging” effect. Creditable foreign taxes are limited so that the average creditable foreign rate (not any actual foreign rate) does not exceed the US rate. Consequently, the high-tax European income shelters the low-tax other foreign income. In fact, Sue may have done some surgeries in low-tax countries in order to exploit averaging.

Why is the US so dumb? One argument is simplicity: Separate limits on each item of foreign income (or even on income from each country) are unworkable, say the lobbyists. Also, business argues that averaging encourages trade. The 1986 tax act put some limits on averaging, but the pending ETI bills would soften them. Oh, well.

Tomorrow: foreign subsidiaries.

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7 Responses to US Taxation of Multinational Enterprise: Part V

  1. Tom says:

    A foreign tax credit is obviously necessary to avoid multiple levels of U.S. and foreign income taxation on the same income. That’s why the deduction alternative should be unacceptible as an anti-trade/investment measure. Someone gave an example of the different effective tax rates with hypothetical numbers in another discussion thread on one of the other parts to this article. The effective tax rate differential between a credit and a deduction can be quite substantial (effective rate with deduction much higher than with credit) and obviously would discourage U.S. investment outside the U.S. I refuse to believe that Professor Mundstock does not “understand the welfare effects of international trade at this time.” (For that matter, I am not sure what he really means by that statement.) In any event, I am certain the good Professor would agree that the absence of a foreign tax credit would impede U.S. investment outside the U.S. I would hope he agrees that such investment is, by and large, a good thing for all. Am I missing something here, Professor?

  2. GeorgeMundstock says:

    Tom, having the US Treasury pay all offshore costs of US businesses also would encourage trade. But, that would be ill-advised, as the benefit to the US is not worth the cost. I am not sure that foreign income taxes are different from rent in London. The US federal income tax does not allow a credit for state and local income taxes for good reasons. As the US becomes a smaller player in the world economy, those reasons apply to foreign taxes as well.

  3. Tom says:

    Now hold on a minute, Wilbur. Of course, income taxes, foreign and domestic, are different from rent. First, and most obvious, aside from the intangible benefits all persons derived from government, income taxes do not compensate for any value that might be added to the product or service ultimately producing the taxable income. (Indeed, if you were a true believing republican neocon, you’d probably assert that government does not provide even an intangible benefit.) As a result, unlike rent, income tax may not be readily incorporated into the cost of goods or services sold to increase the sale price. Second, . . . well, actually, I don’t have a “second,” but I think (or was I merely taught) that the FTC mitigates multiple taxation that could become prohibitive absent the credit. If the credit is disallowed, or earnings are always forcibly repatriated for U.S. taxation annually, U.S. business would be discouraged from investing outside the U.S. because the additional U.S. income tax would likely place the U.S. investor at a disadvantage when competing against non-U.S. investors.

    I will be the first to admit I do not fully understand the effect of U.S. and foreign taxation on the competitiveness of U.S. trade and investment, but you have not truly explained your suggestion that the FTC is ill-advised. The failure to provide a U.S. income tax credit for state and local taxes does make U.S. businesses or investors less competitive since foreign investors in the U.S. receive identical U.S. income tax treatment on their payments of state and local taxes. But the income tax situation overseas is not necessarily equalized by a deduction for foriegn income tax payments since a non-U.S. investor may not be subject to multiple taxation where, for example, the investor’s home country does not tax foreign source income at all. Anyway, that’s my story and I’m sticking to it, Wilburrrr.

  4. paul lukasiak says:

    I think there is a very serious flaw in any argument that assumes that the benefits derived from government are all intangible.

    What, for instance, would it cost individuals and corporations to secure their assets if there were no police?

  5. GeorgeMundstock says:

    Paul, Word up! (Please forgive a 50-something pathetically trying to sound hip. After all, the only hip hop I ever liked was Gil Scott-Heron.) They key to future political debates about taxation is to undermine the right’s tacit assumption that business owes nothing to government — that taxes are all a dead weight drag on the engine of capitalism. Capital exists because of government, d**n it!

  6. Tom says:

    Paul, I probably did overstate the “intangible” nature of the benefits received from government services a bit, but the underlying point is nonetheless correct. The services provided by any particular local government are basically the same for all resident businesses and investors, and the equation of the cost of government (i.e., taxes) to other costs of production makes little sense. Without the FTC, U.S. businesses and investors could clearly be placed at a competitive disadvantage overseas since not all competitors play by the same tax rules. However, until he explains himself, George is just plain being obstinate. Aren’t you, George?

  7. GeorgeMundstock says:

    Tom presents the fundamental issue of international taxation: if all factors are freely mobile, can taxes be more than a user fee? If not, progressive taxation — and democracy? — are history. Which gets back to the question that this discussion started with and tabled: Can we deal with Sue’s mobility? I hope to get to that issue — with only some ideas — before Michael Froomkin returns to get this blog off taxes….


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