Current U.S. CIT Regime

5. The U.S. corporate tax couples a high statutory tax rate—39.2 percent including average state and local corporate taxes—with a narrow base. PERAB (2010) estimates that eliminating all major corporate tax expenditures would allow a 7-point cut in the federal CIT rate to 28 percent on a revenue-neutral basis. The largest three business tax expenditures are accelerated depreciation, which costs $507 billion over ten years, research and experimentation expensing ($152 billion), and the domestic production activities deduction ($127 billion). Although generous depreciation and research allowances stimulate new investment at the margin, a high overall rate burdens mature, profitable corporations. Moreover, a proliferation of tax expenditures distorts investment decisions and promotes extensive tax planning.

6. The U.S. worldwide tax system with deferral taxes corporations on their worldwide income, with a credit given for foreign income taxes (CIT and withholding taxes). However, active business earnings from controlled foreign corporations (CFCs), subsidiaries in which a U.S. parent holds at least a 10 percent share, are not taxed by the U.S. until repatriated as dividends. This gives companies an incentive to retain earnings in low-tax jurisdictions offshore.

7. In addition, U.S. accounting rules encourage retaining profits offshore. Accounting Principles Board Opinion (APB) 23 provides that corporations that elect to retain profits offshore indefinitely do not have to recognize a deferred tax liability with regard to those profits in their financial statements; reported earnings for firms that elect to do so will thus be higher, potentially boosting their share prices. Graham et al. (2011) show that APB 23 is an important factor encouraging corporate managers to avoid repatriation. Moreover, corporations are not required to hold their “unrepatriated” earnings offshore: Under IRC 956(c)(2), they may reinvest them in U.S. financial assets without being forced to recognize them as repatriated dividends for tax purposes.⁵ A 2011 report by the Senate Permanent Subcommittee on Investigations finds that 27 of the largest U.S. corporations hold an average of 46 percent of their total $538 billion in undistributed foreign earnings in U.S. financial assets (cash, Treasury securities, and stocks) deposited with U.S. financial institutions.

8. A small share of U.S. MNE foreign earnings is repatriated in most years, and the stock of earnings held offshore is large: about $1.7 trillion in 2011 at 1,113 U.S. corporations (Altshuler and Grubert, 2012; JP Morgan, 2012). MNEs may have non-fiscal motives for retaining earnings abroad—such as more profitable investment opportunities or hedging foreign currency risk—but current tax policy is widely regarded as a significant factor. Desai et al. (2001) find that the repatriation tax reduces dividend payments by about 13 percent. The results of the 2005 repatriation tax holiday, in which MNEs that repatriated earnings for selected purposes faced a residual U.S. tax of only 5.25 percent in that year, also suggest that tax is an important factor in deterring repatriation: MNEs temporarily boosted repatriations from an average of about $60 billion per year to $320 billion in 2005.

9. The U.S. worldwide regime gives rise to several common forms of tax planning that shifts profits from high-tax to low-tax jurisdictions. Transfer pricing practices, in which an affiliate in a low (high) tax country underpays (overpays) for goods or services, are widespread and difficult to prevent where unique assets such as intellectual property are concerned. Real investment and profit shifting are linked insofar as companies with more capital invested outside the U.S. have a greater capacity to (credibly) shift profits offshore. The ability to shift profits also depends on the economic sector; those with more investment in intellectual property, such as pharmaceutical and information technology companies, have greater capacity to shift profits.

10. The 1997 “check-the-box” rules allow business entities to elect their form of business for U.S. tax purposes. This provision facilitates widespread cross-border tax avoidance through the use of “hybrids”: entities that are treated as different forms of business by different governments. Grubert (2012) estimates that check-the-box rules contributed 1–2 percentage points in the roughly 5 percent decline in U. S. MNE foreign effective tax rates since 1997. Under a dividend exemption system, check-the-box would become largely irrelevant with respect to exempt foreign income.⁶

11. Deferral, cross-crediting and tax planning appear to be eroding the U.S. corporate tax base over time. The foreign share of U.S. MNE earnings has been growing over time, from 37.1 percent in 1996 to 51.1 percent in 2004.⁷ Low-tax jurisdictions show higher rates of profitability relative to sales and assets than higher-tax jurisdictions, including the U.S., suggesting that some profit is successfully shifted to low-tax jurisdictions. MNEs tend to owe very little U. S. tax on their foreign source income: GAO (2008) reports that in 2004 the effective U.S. tax rate on the foreign-source income of large U.S. MNEs was 4 percent, vs. 25.2 percent on their domestic earnings.

International Impact of U.S. Corporate Tax Reform

12. The U.S. accounts for the largest share of global FDI stocks (both inbound and outbound), suggesting that U.S. CIT changes could have important spillover effects for the rest of the world. In 2010, the U. S. accounted for 18 percent of the global stock of inward FDI, compared to 9 percent for the second largest FDI recipient (China, including Hong Kong S.A.R.); and 24 percent of the global stock of outward FDI, compared to 8 percent for the second largest FDI source (the United Kingdom). While the discussion and analysis of U.S. corporate tax reform tend naturally to focus on the impacts on the U.S. economy, the leading role of the U.S. in cross-border investment activity implies that U.S. CIT reforms could generate significant spillovers for other countries. U. S. CIT changes can affect other countries through multiple channels, requiring that the spillover impacts be evaluated against several criteria. In the remainder of this note, we analyze the international spillovers from various U. S. CIT reform proposals against the following criteria:

• Impact on real investment activity: Changes in the U. S. tax treatment of corporate profits can potentially alter the decision of U.S.-based C-corporations between domestic and overseas investment. The attractiveness of the U.S. as an investment location for foreign firms, compared to investment in their home or other foreign countries, may also be affected. While the literature tends to conclude that non-tax factors are important determinants of multinational firms’ location decisions, the elasticity with respect to tax rates is typically found to be reasonably large.⁸ FDI is thought to embody knowledge and technology that are sources of beneficial spillovers to the host economy, implying that any changes in FDI patterns can have important effects on the economic performance and welfare of the rest of the world.

• Impact on profit shifting: Profit shifting to low tax jurisdictions represents a different margin of behavioral response to cross-country tax differences than the location decision for real investment activity, although the opportunity to engage in profit-shifting behavior may increase the attractiveness of locating real activity in low-tax countries. Low-tax countries collect some revenues as a result of these shifted profits and hence would be affected by any U.S. tax changes that alter the incentives for U.S. firms to engage in profit shifting.

• Tax competition: The previous decade has witnessed competition among industrialized countries to attract growing volumes of footloose international investment, focused on reductions in statutory CIT rates. Countries may also choose to use more targeted tax incentives to attract inward investment. Any sizable U.S. CIT reform can therefore be expected to elicit a tax competition reaction by other countries, either through changes in their CIT rates or through changes to the design of their tax base.

13. Various measures are used to capture the tax burden on profits and the tax disincentive for new investment, and their relevance will differ depending on the spillover channel that is being analyzed. The tax burden on profits earned from investment and the tax disincentive for new investment depend in practice on a range of factors including the statutory CIT rate, the tax base (notably the tax treatment of depreciation of assets), the way in which foreign income is taxed and the opportunities for firms to engage in tax planning. (Box 1).

Reduced CIT Rate

14. The trend toward lower statutory CIT rates among OECD countries has raised concerns that the U.S. CIT rate undermines U.S. competitiveness and spurs taxable profit shifting. Statutory CIT rates in OECD member countries dropped on average by 7.2 percentage points between 2000 and 2012 (Figure 1) to 25.4 percent. Following the cut in Japan’s national CIT rate in March 2012, the combined national and local CIT rate in Japan fell from 39.5 to 38 percent, making the U. S. CIT rate of 39.2 percent the highest in the OECD.⁹ The U.S. effective average and marginal corporate tax rates are also above the average for G-20 countries (Figure 2). A growing CIT rate differential between the U.S. and other advanced economies spurs multinational corporations to shift profits out of the U. S. through various tax-planning measures.

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Statutory CIT Rates in OECD Countries, 2000 and 2012

(percent)

Citation: IMF Staff Country Reports 2012, 214; 10.5089/9781475504910.002.A006

Sub-central government taxes are included. United States rate is based on a weighted average of state marginal corporate income tax rates.Source: OECD Tax Database (www.oecd.org/ctp/taxdatabase).

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Effective Average and Marginal Corporate Tax Rates in G-20 Countries, 2011

(percent)

Citation: IMF Staff Country Reports 2012, 214; 10.5089/9781475504910.002.A006

Countries ranked by effective average tax rate (EATR). EMTR is effective marginal tax rate. Assumes the following asset weights: Plant & machinery 25.6 percent; Buildings 24 percent; Intangible assets 8.7 percent; and Inventories 41.7 percent. The investments are assumed to be 35 percent debt financed and 65 percent equity financed. Source: Bilicka, Devereux and Fuest, 2011.

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15. A U.S. CIT rate cut would lower the global tax burden on investment and would likely increase both U.S. domestic investment and FDI.¹⁰ As the U.S. currently has the highest statutory CIT rate in the world, a U. S. CIT rate cut would lower the global tax burden on all forms of investment—domestic U.S. investment and U.S. inward and outward FDI. If the U.S. CIT rate were not the world’s highest, then a rate cut would not reduce the aggregate tax burden on U.S. inward FDI from a higher tax country that taxed worldwide income. Also, if the U.S. did not tax worldwide income, then a U.S. CIT rate cut would not affect the tax burden on U. S. outward FDI. The combination of the high CIT rate and worldwide taxation ensure that a U. S. CIT rate cut would reduce the global tax burden on investment and could stimulate increased gross investment flows of all types.

16. A cut in the U.S. CIT rate would reduce the tax burden on U.S. domestic and outbound corporate investment, but the former effect is likely to dominate. Without accompanying reforms to broaden the U.S. CIT base, a rate cut would generally reduce the U.S. marginal effective tax rate (METR),¹¹ resulting in increased levels of investment in the U. S. by domestic investors. More importantly in terms of international spillovers, a rate cut would reduce the residual U.S. tax on any foreign income that U.S. multinational firms earn.¹² The resulting reduction in the average effective tax rate (AETR) on outbound investment would tend to generate increased levels of U. S. outward FDI, with potentially beneficial effects on the economic performance and tax revenues of recipient countries. In practice, to the extent that domestic U.S. investment and outbound FDI are substitutes, a U.S. rate cut might cause U.S. companies to substitute domestic investment for FDI. In addition, the combination of deferral and tax planning strategies already limit the effectiveness of U. S. taxation of foreign income. Hence, it is possible that outbound FDI could respond negatively to a U. S. CIT rate cut.

17. The increased attractiveness of the U.S. as a location for FDI may divert investment from other countries, but the impact would likely be limited to advanced countries. A wide body of research shows FDI to be highly sensitive to the host country CIT rate, with a semi-elasticity of −2 to −3.¹³ The increased post-tax return on inbound investment into the U. S. would likely divert FDI from other competing locations. Firms that might previously have invested in their home countries might also opt instead to invest in the U.S. following a U.S. CIT rate cut, to the detriment of their home countries.¹⁴ This effect is likely to affect only advanced economies, which account for the large majority of outbound FDI, with little impact on developing countries.

18. The effects of a U.S. CIT rate cut on portfolio investment by corporate entities should be similar to those on FDI flows. Most countries – including those that operate territorial tax regimes for active business income—tax the foreign passive income of their resident companies. U.S. corporations that engaged in passive investment overseas would experience a lower residual U.S. tax burden on repatriated passive income. This in turn would provide them with greater excess foreign tax credits with which to offset U.S. tax due on other forms of overseas passive income under Subpart F rules.

19. A U.S. CIT rate cut would also reduce the incentive for multinationals to shift profits overseas, to the detriment of tax revenue collections in some low-tax jurisdictions. The incentive for multinational firms to shift profits from high- to low-tax jurisdictions, either through the manipulation of transfer prices on intra-firm transactions or through intra-group financing arrangements, is a function primarily of cross-country differences in statutory tax rates. Research shows that profit-shifting is less sensitive to relative CIT rates than FDI, but the semi-elasticity is still substantial at about −1.¹⁵ A U.S. CIT rate cut will lead to the net shifting of profits from foreign jurisdictions into the U.S., reducing the tax base and revenue collections especially of low (but non-zero) tax countries. The reduced incentive for U. S. companies to shift profits might in turn reduce the attractiveness of low-tax countries as locations for real investment, leading to some fall in outbound U. S. FDI into these countries that offsets (at least in part) the positive effect of reducing the residual U.S. tax on outbound FDI.

20. A rate cut in the U.S. might also prompt a new round of tax competition in both statutory rates and investment incentives. As discussed above, the last decade has seen tax competition induce a nearly universal decline in CIT rates among OECD countries. The effect of a U. S. rate cut on statutory rates in other advanced economies may be particularly powerful, given its role as the world’s largest source and recipient of FDI.¹⁶ Under the current regime, any rate cut by other countries would in part transfer revenues paid by U. S. multinationals to the U. S. Treasury. A U. S. CIT rate cut would reduce the residual U. S. tax burden on outbound FDI and may therefore prompt other countries to lower their statutory rates. However, this argument abstracts from the reality that deferral and tax planning limit the effectiveness of U.S. taxation of foreign income, providing countries with some space to cut their CIT rates.

21. Alternatively, other countries might grant more generous tax incentives targeted at foreign investors, in order to avoid giving a windfall tax cut to their domestic investors. A CIT rate cut designed to attract internationally mobile investors will lead to an inefficient revenue loss for the government, as domestic investors who are less internationally mobile will also benefit. To avoid providing this windfall gain to domestic investors, governments may instead opt to introduce generous non-rate tax incentives targeted at foreign investors. This form of intensified tax competition would narrow tax bases and erode corporate tax revenues in other countries.

22. Non-corporate entities would not directly benefit from a CIT rate cut, dampening its effect on real investment and profit-shifting behavior. In 2007, non-corporate pass-through entities, which include sole proprietorships, partnerships and S-corporations, accounted for 94 percent of the number of businesses, 47 percent of net income, and 34 percent of business tax revenue in the U. S. These pass-through entities would experience no direct change in their incentives to engage in outward FDI or to shift profits between the U.S. and foreign jurisdictions. However, in practice, a lower CIT rate might prompt some pass-through entities to incorporate, resulting in PIT revenue losses—but the likely size of this behavioral response is uncertain.¹⁷

Broadening the CIT Base

23. The U.S. might also consider measures to broaden the corporate tax base, with the revenue gains used either for fiscal consolidation or to pay for a CIT rate cut. The major current business tax expenditures are: 1) accelerated depreciation, which costs $507 billion over ten years; 2) research and experimentation expensing, which costs $152 billion; 3) the domestic production activities deduction (a broad tax break for domestic manufacturing, which was introduced in 2004 to replace export incentives that violated WTO rules), which costs $127 billion; 4) non-FIFO inventory methods, which cost $70 billion; and 5) the low-income housing tax credit, which costs $33 billion.¹⁸ Reducing depreciation allowances is a standard means of base-broadening that most OECD countries have used to offset rate cuts in recent decades. This section considers the spillover effects of U.S. base broadening measures in isolation, while the next section considers the effects of a revenue-neutral package of base broadening and rate cuts.

24. U.S. base broadening reforms are unlikely to have a significant impact on the size or location of outbound U.S. foreign direct investment. Under U.S. tax rules,¹⁹ U.S.- resident companies are required to calculate their foreign taxable incomes using rules that differ from those that apply when calculating their taxable income from domestic U. S. sources. In particular, these rules restrict the availability of accelerated depreciation allowances for tangible property used predominantly outside the U.S. The implication is that reforms to broaden the U.S. corporate tax base—for example, reducing the generosity of depreciation allowances—would not directly impact the effective tax rate on outbound U. S. FDI. However, because base-broadening reforms would increase the METR on domestic U. S. investment, they could cause an increase in outbound U. S. FDI. The size of the increase in METRs will differ across sectors, depending on the nature of the base-broadening reforms. Capital-intensive manufacturing sectors would be especially impacted by less generous accelerated depreciation allowances, while reforms to research and development tax incentives would particularly impact knowledge-intensive sectors such as pharmaceuticals. As sectors differ in their FDI intensity, the precise nature of base-broadening reforms would play a role in determining whether U.S. companies choose to switch from domestic U.S. investment to outbound FDI.

25. Most types of base broadening reform should not lead to any change in profit shifting behavior. As discussed above, the incentive to engage in profit shifting is determined primarily by the difference in statutory CIT rates between the U.S. and other countries. This incentive would be largely unaffected by reforms that broaden only the U.S. CIT base and hence low-tax foreign countries would expect to see no loss in revenues collected as a result of profit shifting behavior. An exception might be base broadening reforms that limit the favorable U.S. tax treatment of debt finance (for example, limiting deductions for interest payments), which might encourage U.S. firms to shift their debt to foreign jurisdictions with more favorable treatment.

26. Tax competition effects are likely to occur through changes in the generosity of investment incentives in the rest of the world, but the direction of change is uncertain. The tax competition literature typically presumes that effective tax rates across countries are strategic complements, so that an effective tax rate increase in the U. S. would be expected to be accompanied by effective rate increases elsewhere. This would be consistent with a positive demonstration effect, whereby U.S. base broadening stimulates similar reforms elsewhere, in the way that the 1986 U.S. tax reforms to lower the CIT rate and broaden the base came to be seen as a model for tax reform in other countries. However, it is possible that scaling back U. S. tax incentives targeted at internationally mobile forms of capital—for example, the research and development tax credit²⁰—could lead multinational firms to seek alternative investment locations. This in turn could prompt other countries to increase the generosity of their tax incentives as they compete to attract the investment displaced from the U.S. It is unclear which of these effects would dominate, but the net effect on the intensity of tax competition will depend on the nature of the base broadening reforms in the U. S. and the types of investment activity that would be affected.

27. Non-corporate entities would be affected by base broadening reforms. The net income of non-corporate pass-through entities is determined using the same tax accounting as corporate income, so broadening the corporate tax base also eliminates deductions for non-corporate businesses. The analysis of the impacts of base broadening reforms therefore applies equally to corporate taxpayers and to pass-through entities.

Revenue-Neutral CIT Rate Cut with Base Broadening

28. JCT (2011) estimates that eliminating all significant CIT expenditures would enable the CIT rate to be cut to 28 percent on a revenue-neutral basis. However, this does not take into account the effect of broadening the business tax base for non-corporate businesses, which currently account for a large share of U.S. production. JCT (2011) estimates that eliminating business tax expenditures would increase PIT revenues from pass-through entities by roughly $300 billion over ten years. In practice, some of these pass-through entities will determine that they would be better off under the lower-rate CIT regime and convert to C-corporations, which will shift revenue from the PIT to the CIT and lower the revenue gain from business tax base broadening. The magnitude of this effect is uncertain and will depend on the non-tax benefits that businesses derive from operating as pass throughs.

29. A revenue-neutral combination of base broadening and a CIT rate cut would likely lead to a modest increase in outbound U.S. FDI. The precise impact of this reform would depend on the nature of the base broadening reforms, but as a first approximation it is reasonable to assume that the METR on domestic investment in the U.S. would be largely unchanged. As discussed above, the base broadening would have no direct impact on outbound U. S. FDI, due to the different tax base rules applied to foreign income, but the CIT rate cut would reduce the residual U.S. tax on foreign earnings of U.S. multinationals. In net terms, the AETR on outbound U.S. FDI is therefore likely to fall, resulting in slightly more outbound U. S. FDI.

30. Most revenue-neutral reforms would lead to the same incentive for net profit shifting into the U.S. as a CIT rate cut in isolation. As discussed, profit shifting behavior is driven primarily by cross-country differences in statutory income tax rates. Accompanying a U.S. CIT rate cut with base broadening would therefore lead to the same net shifting of profits into the U. S. as a stand-alone rate cut. The exception would be where U. S. base broadening is achieved through less generous tax treatment of debt finance, which would encourage greater profit shifting into the U.S., reinforcing the impact of a standalone U.S. CIT rate cut.

31. A cut in the U.S. CIT rate, even if accompanied by base broadening, can be expected to prompt rate cuts elsewhere in the world. As discussed, a U.S. CIT rate cut reduces the residual tax on outbound U.S. FDI, while base broadening reforms would not affect the effective tax rate on foreign income of U.S. multinationals. Following a U.S. CIT rate cut, foreign jurisdictions would face an incentive to cut their own CIT rates in order to attract U.S. investment.

32. However, implications for the tax bases of other countries would be ambiguous. Assume that the U.S. reform leaves U.S. METRs broadly unchanged, and that the U.S. CIT rate cut sparks tax competition in statutory CIT rates elsewhere in the world. If the rest of the world were to leave its tax base unchanged, then METRs in other countries would fall due to their statutory rate cuts. This in turn would imply that METRs in the U. S. and in the rest of the world are strategic substitutes. In fact, the tax competition literature tends to suggest strategic complementarity of effective tax rates across countries, suggesting that other countries would respond to U.S. base-broadening reforms with similar reforms of their own. However, once again the precise nature of the U. S. reforms is important. If the U. S. were to reduce the generosity of incentives for footloose activities such as R&D, then this might prompt other countries to offer more generous incentives to attract any displaced U. S. activity.

Territoriality

33. Moving to territoriality would repeal U.S. taxation of dividends of foreign subsidiaries, so that active foreign-source earnings would be subject only to host country taxes. Two different measures could be applied in order to address U. S. deduction of expenses incurred to support exempt foreign earnings: Corporations could be required to allocate expenses between taxable domestic activity (allowed) and exempt foreign earnings (disallowed); alternatively, a “haircut” tax of around 5 percent could be applied to foreign active income, regardless of whether it is repatriated. The haircut would likely raise less revenue than expense allocation, although expense allocation would be administratively more challenging. Several countries with territorial systems including France, Germany and Japan impose a haircut, but no major country requires expense allocation.²¹ The U.S. could also tighten its thin capitalization rules to prevent income from being stripped out of the U. S. via excessive interest payments.²²

34. The impact of territoriality on real investment depends on the relative effective tax rates (both marginal and average) of the U.S. and foreign host countries. Where low-tax countries are concerned, repeal of U.S. tax on repatriated foreign dividends will increase the tax differential between domestic and foreign investment, so U. S. outbound FDI should be stimulated. However, the loss of excess tax credits from high-tax countries, which are often used to shelter income from lower-tax countries, could lead to heavier taxation of earnings from low-tax countries, offsetting this effect. In any event, because little residual U. S. tax on foreign earnings is paid, the stimulus to outbound FDI would likely be small. The effect of territoriality on FDI to high tax rate countries would likely also be small; however, some of that investment may be siphoned off to lower-tax countries, because the effective tax rate differential between high- and low-rate countries would also increase.

35. Reduction or elimination of repatriation taxes should lead to greater dividend payouts by foreign subsidiaries, thereby reducing their investment abroad. Prior to 2005, the burden of repatriation taxes was thought to be small, as MNEs could use various devices to access deferred dividends short of actually repatriating them (Altshuler and Grubert, 2003).²³ For example, firms could invest earnings passively abroad and borrow against them, or repatriate them in the form of interest or royalties. However, the large repatriations during the 2005 repatriation tax holiday indicated that, in fact, the costs of retaining earnings abroad in many cases were significant (Grubert and Altshuler, 2012). Repealing the residual U.S. tax would likely result in increased repatriation that could reduce the financial capital available abroad. However, given that 46 percent of “offshore” earnings are already invested in U.S. securities, an increased level of repatriation need not significantly reduce overseas (active or passive) investment. Further, there is some question as to whether moving to territoriality actually results in reinvestment of foreign earnings at home. Dharmapala et al. (2011) find that, despite legal constraints on the use of repatriated earnings in the 2005 tax holiday, most were actually used to pay dividends or buy back shares.

36. Repeal of the repatriation tax would increase the U.S. effective tax rate differential with low-tax countries, sharpening the incentive to shift taxable income out of the U.S.. This would contract the U.S. CIT base but expand that of lower-rate countries. These effects could be limited by expense allocation, more stringent thin capitalization rules, or a minimum tax on foreign earnings; a U.S. rate cut would also temper this effect. Due to the relatively high U. S. CIT rate, highly profitable companies in the information technology and pharmaceutical industries, for example, are already known to be stripping income out of the U.S. If territoriality raises the return to doing so, less profitable companies would follow suit.

37. A U.S. move toward territoriality could put downward pressure on foreign CIT rates, since the “shelter” provided by the U.S. foreign tax credits will disappear. In theory, as long as the U. S. has a worldwide system, foreign countries have the opportunity to set their CIT rates just marginally below the U. S. CIT rate without discouraging U. S. FDI. In practice, however, the value of this shelter is attenuated due to deferral. As noted above, U. S. FDI has been shown in numerous studies to be sensitive to host country CIT rates; thus even under the current worldwide system with deferral, foreign countries experience a significant amount of tax competition that would likely intensify with a U.S. move to territoriality.

38. U.S. territoriality would lessen pressure on foreign countries to design business taxes that qualify for CIT creditability. In order to qualify for creditability under the U. S. worldwide tax system, foreign country business taxes have to be classified as income taxes. Consumption-type taxes such as R-base cash flow taxes with full expensing and no interest deductibility, which are less distortive than a CIT, have therefore been discouraged.²⁴ This has been stumbling block for several countries including Canada and Mexico.²⁵ A U.S. move toward territoriality could thus enable a shift toward more efficient business tax design abroad.

39. On the whole, the net impact of a U.S. move to territoriality on foreign countries is unclear. They might see marginally higher rates of FDI, but could also lose investment due to dividend repatriation. They could benefit from a modest increase in income shifting. Downward pressure on their CIT rates could increase, but impediments to enacting more efficient forms of business taxation, such as cash flow taxes, would be lifted. The relative magnitude of these effects is unknown, and would likely vary substantially across countries.

Minimum Tax on Foreign Earnings

40. Both the Obama administration and House Ways and Means Committee chair David Camp (R-MI) have proposed a minimum tax on U.S. foreign earnings. The Obama proposal would embed the minimum tax in the current worldwide regime; Chm. Camp’s proposal would couple it with a move to territoriality. The Camp proposal’s minimum tax regime is similar to that enacted by Japan as part of its move to territoriality.²⁶ Under the Japanese minimum tax, foreign affiliates whose effective tax rate (i.e., the ratio of foreign taxes to earnings) is less than 20 percent are subject to current taxation at the full domestic rate, with a credit issued for foreign taxes paid. However, the Japanese minimum tax does not apply to foreign affiliates conducting an active trade of business in their host country, a provision designed to restrict its applicability to passive businesses (e.g., holding companies) located in tax havens.²⁷ Similarly, the Camp anti-abuse option would tax income earned by a foreign affiliate (branch or subsidiary) only if it is neither active business income nor taxed at an effective rate of at least 10 percent²⁸ as subpart F income.

41. Under the administration proposal, if a foreign subsidiary’s effective tax rate in a particular jurisdiction is not at a certain (as yet unspecified) level, then the earnings would be taxed without deferral at that rate. The minimum tax would apply to branches as well as subsidiaries. Many details of the Administration’s proposal remain unspecified, and these will determine how it interacts with the CIT and how easily it can be eroded by tax planning. Presumably, any minimum tax paid would be credited against future CIT liability on repatriated earnings, but it is not clear whether any share of repatriated dividends would be exempted from U.S. taxation as a result of having paid the minimum tax.²⁹ It is also not clear whether, like the Japanese tax and Camp option, the Administration’s proposal would contain an exception for active businesses. This would exempt active businesses in tax havens, such as tourist facilities, from paying higher taxes if owned by a U.S. parent, but would also greatly increase opportunities for avoidance.

42. The administration’s proposed minimum tax would not apply to countries with effective CIT rates equal to the minimum tax rate or higher. Note that the effective tax rate, the ratio of taxes to earnings, depends not solely on the statutory CIT rate, but on the definition of the tax base as well.³⁰ In general, a host country with a statutory CIT rate equal to the minimum tax rate will have a lower effective rate if it offers any corporate tax incentives, such as accelerated depreciation or investment credits. For countries with effective rates below the threshold—many but not all of which are tax havens³¹—both FDI and inward income shifting would likely fall. These effects could be small, however, depending on the minimum tax rate chosen: If the federal CIT rate were cut to 28 percent under the President’s proposal and the minimum tax rate set at 15 percent, the remaining 13 point spread between the U.S. CIT and the minimum tax³² would still offer an incentive to shift income offshore.

43. If imposed in a manner that is not easy to plan around, the minimum tax could alleviate downward pressure on foreign countries’ effective CIT rates, similar to a U.S. repeal of deferral. Countries could raise their effective CIT rates to the U. S. minimum tax rate without fearing a loss of U.S.-source FDI or income tax base. This measure has the potential to limit business tax competition for low-CIT rate countries seeking real investment, while lowering the attraction of channeling income through tax havens.