President Obama has announced plans to change United States tax law to increase taxability of overseas subsidiaries of American companies.
Let's look at how this works.
American companies which now compete in overseas markets on similar footing to their local competitors, by paying similar local tax rates and thus achieving similar after-tax returns on investment, would no longer be able to check a box to avoid U.S. taxation of those operations. Operations in many parts of the world -- those parts with higher-than-U.S. tax rates -- will be unaffected in practice because the United States would still collect no tax: the local operations would be taxed at higher local rates, and under U.S. tax treaties designed to prevent double taxation, the Internal Revenue Service would collect no further tax on those earnings. The new rule would impact businesses operating in those jurisdictions with lower-than-U.S. tax rates.
In these low-tax jurisdictions, the competitiveness of non-local business depends in part on the taxing policy of their parents' governments. American-style "we tax you on your worldwide income" policy results in taxpayers facing a 35% tax rate floor regardless where they situate operations (well, with the exception that certain economic zones carved out by Congress for special tax treatment might get better deductibility of expenses or the like; the tax code is rife with favoritism ... ask any sugar farmer). So in a 10% tax jurisdiction, local firms with $1 of profit will end up with $0.90 to reinvest after taxes, whereas an American competitor with the same performance would have $0.65 to reinvest -- assuming the jurisdiction has a tax treaty that prevents double taxation, without which the American operation would have a post-tax profit of $0.55 (after paying both U.S. federal income tax at the 35% rate and tax at the local 10% rate). The difference -- the $0.25 or $0.35 -- is unavailable to pay dividends to U.S. owners, be split into profit-sharing plans for U.S. employees, or used to uprade companies' U.S. facilities and infrastructure that make the company's worldwide operations possible.
The jump from $0.65 to $0.90 is a 38.5% gain. Improving after-tax profit by 38.5% is so attractive -- this isn't an increase in taxable income, mind you, but after-tax income, making it a much more valuable way to gain an additional $0.25 than one ordinarily is able -- that organizations facing this situation have a very powerful motive to avoid the extrajurisdictional tax. (In the case of a jurisdiction without a tax treaty with the U.S. to prevent double-taxation of income, the motivation becomes much more severe -- as it does in the case of a foreign jurisdiction with an even lower tax rate wuch as 5%, 3%, or 0%.) Careful evaluation of the tax rules will always turn up ways to avoid unnecessary taxation, because the rules for taxing incomes have never been simple -- especially across the borders of countries with which the United States has tax treaties.
Tax avoidance is not the same as tax evasion: it's lot a lie told to prevent government from learning the true extent of one's tax obligation, it's a decision to structure transactions in such a way as to enjoy the benefit of the tax rules. As a hypothetical, imagine a corporate owner deciding not to pay himself a multimillion dollar salary (which would be taxable as ordinary income) but to richly fund an employee benefit plan (which depending on the type of benefit could be exempt from taxes, could result in deferral of tax payment until some future distribution date, or could be a deductible expense and thus paid for with pre-tax dollars) while reinvesting against the day he sells his shares (for a long-term capital gain, taxed at a more favorable rate). This decision would be tax avoidance, not evasion: it requires neither deceit nor illegal activity to conduct. It's why companies engage in tax planning. Tax planning is a big high-dollar business -- precicely because every dollar saved with tax planning is an after-tax dollar.
The expected outcome of international tax planning in the face of the proposed checkbox elimination is not difficult to imagine: fewer U.S. companies doing international business through foreign subsidiaries. Instead, foreign-sited business (whose owners would include, perhaps in numerous minority stakes, Americans who used to do business abroad directly) would do business in the U.S. through owned subsidiaries, if at all, with the rest of their worldwide operations never touched by American tax laws. Efforts to attch U.S. income taxation to listings on major exchanges is sure to fail: major exchanges include numerous foreign corporations' ADRs (American Depository Receipts) that trade just like shares, and the United States would be unable to reach them with U.S. tax laws. It would be hard to see how Americans structuring foreign public companies with US-traded ADRs would fare differently, unless we restructured the rules to make non-US companies prefer to trade on some non-US exchange. (How's that for progress?)
Americans would continue to compete against all comers at home, but would generally not compete abroad. Americans who employ tax advisors would organize operations so that all non-US business was conducted through entities that never did any business in the United States (other than perhaps through subsidiaries or partners which would bear the U.S. taxes) and thus never fell within the reach of U.S. tax laws. Certainly, some businesses with highly-concentrated ownership would be unable to appear non-US in nature and would be stuck with worldwide U.S. taxation -- family businesses, for example -- but the really big organizations would presumably be able to structure their affairs to avoid U.S. taxes until U.S. tax law finally attempted to tax on their worldwide incomes all corporations wherever situated regardless who owned them and regardless whether they ever did any business in the United States. However, the 38% increase in after-tax income will surely draw multiple owners into collaboration to co-own foreign entities in small minority slices, for the express purpose of gaining an overnight 38.5% increase in take-home profits.
Assuming that U.S. tax law doesn't soon purport to tax on their worldwide incomes all corporations wherever situated regardless who owned them and regardless whether they ever did any business in the United States, avoidance of U.S. taxes by firewalling U.S. operations from foreign holding companies is likely to be the principal result of eliminating the checkbox. More money will be made by those who offer tax advice and structure international business organizations, but not much more will be collected by the Internal Revenue Service (except through increased income taxes collected from tax advisors enriched by harshening U.S. tax policy).
Assuming we don't want to lose American competitiveness abroad, we should be looking at ways to ensure foreign profits come home, not ways to ensure they are punished.
Unfortunately, American efforts to control markets have a pretty bad history of improving the status of foreign competitors. We wanted to reduce the number of physicians in the U.S., so we reduced funding for seats in medical school -- reducing U.S.-trained physicians. Of course, residency programs still want trainees to do work in their programs, so we import non-US physicians every year by the thousand. Foreign-trained medical students unable to get into U.S. medical schools have become so ubiquitous that they are a stock figure in caricatures of the modern medical establishment. Why are we helping foreigners to get high-dollar prestige jobs here in the U.S. at the expense of Americans, able to speak English intelligibly, who would happily have done similar work had medical schools not been shrunk in favor of foreign grads?
Our investment in education isn't just enhancing the stock of foreign medical grads. Bill Gates famously called for abolishing federal H-1 visa quotas on the ground that the U.S. wasn't producing enough programming talent. The United States invented programming talent. Why is it we can't be bothered to make training accessible to locals?
Presumably we don't plan to save America by contracting the job to foreigners. Let's think of a plan that does something more sensible, and keeps the money (and the pride) at home.