Earlier this week, we discussed President Obama’s controversial proposal to shift from the current “deferral” system of international taxation to a more expansive system featuring a first-of-its-kind “worldwide” minimum tax.
While you can read the details here, in summary, our current system does not tax the income earned by a foreign subsidiary of a U.S. corporation until those earnings are repatriated to the U.S. Under the proposed worldwide system, however, this deferral opportunity would be partially eliminated through the imposition of a minimum tax to be applied to the income of a foreign subsidiary when it is earned, regardless of when it is repatriated.
Advocates of the shift to a worldwide system argue that it levels the playing field for a U.S. corporation contemplating moving its operations overseas, because establishing a subsidiary offshore would not currently avoid the imposition of U.S. tax. Critics complain that such a paradigm shift would create an administrative nightmare and only provide more motivation for U.S. corporation’s to attempt to “game” the system.
Robert Goulder over at Tax.com takes over where we left off, hypothesizing as to how this worldwide minimum tax might take shape:
The minimum tax would take the form of a low-tax kickout rule that limits the ability of U.S. firms to defer foreign profits. It draws a line in the sand, so to speak, at half the U.S. statutory rate, which drops to 28% under Obama’s framework. That targets an effective rate of 14% (half of 28%) as the threshold for the kickout rule.
Goulder then provides two examples, which illustrate that even with a worldwide minimum tax, a level of deferral can still be had:
Example 1: Irish Profits
A U.S. firm has a foreign subsidiary that earns $100 in Ireland. The Irish corporate rate is 12.5%, so the sub pays a foreign tax $12.50. All the foreign profits ($100) are currently taxed in the U.S. under the new minimum tax (by attribution to the U.S. parent) at a rate of 14%. This results in a presumptive tax liability of $14. The U.S. parent then claims a tax credit for the $12.50 paid in Ireland by the sub; resulting in a residual U.S. tax of $1.50 ($14.00 less $12.50).
Example 2: Cayman Island Profits
A U.S. firm has a foreign sub that earns $100 in the Cayman Islands. The Caymans don’t tax corporate income at all, so no foreign tax is paid. All the foreign profits ($100) are currently taxed in the U.S. under the new minimum tax (14%) by attribution to the U.S. parent. This results in a presumptive tax liability of $14 (same as the Irish sub). But here the U.S. parent has no credit to offset the minimum tax because no foreign tax was paid in the Caymans. This results in a residual U.S. tax of $14.
In Example 1, the U.S. parent pays tax of only 1.5% on the income earned by its foreign subsidiary, with the remaining corporate tax to be paid upon repatriation of the earnings. In Example 2, while the U.S. parent now must pay the full 14% minimum tax on the income earned by its subsidiary, it still enjoys the benefit of deferring the remaining 14% of corporate tax until the Cayman sub’s earnings are repatriated.
So what does this mean for the fate of foreign subsidiaries? Goulder explains:
We can imagine that offshore shell companies might not go away entirely. They’d simply move to venues where they could still enjoy the benefits of deferral. But that would require being in a jurisdiction that actually taxes income. One can imagine a cliff effect where shell companies set up shop just on the right side of the kickout rule [Ed note: a country that imposes its own tax right at the 14% minimum rate.] Rough justice? Perhaps, but such is the nature of drawing lines in the sand.