Tax Analysts Blog

Obama's Corporate Minimum Tax

Posted on Feb 29, 2012

President Obama has given us his framework for corporate tax reform. There's much talk about his proposed minimum tax on offshore profits. The framework is thin on details, but we're able to provide the following preview of how the tax might operate.

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.

U.S. firms could still defer foreign profits in countries where the effective rate exceeds the threshold. So foreign profits in places like Germany or France (i.e., our major trade partners) would be unaffected. Think business as usual; taxes are not paid in the U.S. unless/until the profits are repatriated.

Everything changes in the case of countries with effective rates lower than the threshold. Those profits would be subject to current-year U.S. taxation. That is, on an accrual basis -- just like profits earned domestically.

Many readers will note that accrual treatment of offshore profits is already in the tax code as part of the Subpart F regime. The primary conceptual difference between Subpart F and Obama's minimum tax is that the former reaches a narrow category of profits and is often avoided by clever tax planning, while the latter is much broader in scope and doesn't rely on technical categories of income that can be skillfully manipulated. [Query whether the minimum tax would be necessary if Subpart F did it's job?]

Here's how the President's corporate minimum tax might work in practice

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.

By comparison, current law imposes no U.S. tax in either of these two examples until/unless the sub repatriates the profits -- which might not happen for many years, if at all. [Note: We're assuming the rate of minimum tax equals the low-tax threshold (14%, or half the statutory rate), but it need not be that way. The rate of the minimum tax could be higher or lower than the kickout.]

What can we observe from the above examples?

First, the residual U.S. tax imposed by the minimum tax is far more severe for the Cayman sub than the Irish sub. That's due to the fact Ireland separately taxes the profits. This is inevitable in the design of the foreign tax credit mechanism. The pain inflicted depends directly (and proportionally) on the extent to which the source country forgoes taxing profits in the first place.

Second, 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. Rough justice? Perhaps, but such is the nature of drawing lines in the sand.

This raises a fundamental question which President Obama and his advisors will need to address: Is the goal of corporate tax reform to stamp out deferral wherever it occurs ... or merely to prevent the shifting of profits to tax havens? Stated differently, should anyone care whether U.S. firms park their foreign profits in countries with normal tax rates ... say Germany or France?

What say you?

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