International Tax Policy (for insomniacs)

2009-05-12

If you are having trouble sleeping, this post is for you. Not the most exciting topic, but important nevertheless.

The issue of offshore tax havens and multinational (MNC) profits tax has been big news in the U.S. recently as the Obama Administration considers pushing new rules to make it more difficult for MNCs to defer tax on overseas profits. This obviously has significant repercussions on MNCs doing business in China, particularly those who park their profits in Hong Kong or one of the low tax/no tax islands.

Robert Samuelson of the Post, who has devoted his column over the past couple of months to tearing down most of Obama's policy proposals, hits the mark on this issue.

Like it or not, ours is a world of multinational companies. Almost all of America's brand-name firms (Coca-Cola, IBM, Microsoft, Caterpillar) are multinationals, and the process works both ways. In 2006, the U.S. operations of foreign firms employed 5.3 million workers. Fiat's looming takeover of Chrysler reminds us again that much business is transnational.

For most people, the multinational company is a troubling concept. Loyalty matters. We like to think that "our companies" serve the broad national interest rather than just scouring the world for the cheapest labor, the laxest regulations and the lowest taxes. And the tax issue is especially vexing: How should multinationals be taxed on the profits they make outside their home countries?

No surprise that Samuelson finds that this debate has been framed by politics, with quite of few misconceptions floating around. I don't always take Samuelson at face value, but in this case, I think he's right. Here are the myths he identifies that have been used by supporters of the new policies:

Myth: Aided by those overpaid lobbyists, American multinationals are taxed lightly — less so than their foreign counterparts.

Myth: When U.S. multinationals invest abroad, they destroy American jobs.

Myth: Plugging overseas corporate tax loopholes will dramatically improve the budget outlook as multinationals pay their "fair" share.

Myths two and three are pretty easy to knock down, which Samuelson does well. I think myth number one is a bit more complicated.

Personally, I could give a shit whether a company is taxed "lightly" or "heavily". A better question is are they paying tax in the proper jurisdiction based on their operational activities.

Example 1. An American MNC has its Asia HQ in Hong Kong, from which office they provide a great deal of regional services. A high percentage of regional profits are generated out of Hong Kong, and the MNC is taxed at the (low) Hong Kong tax rate.

This seems fair to me. I would even go so far as to say that if the MNC decides to repatriate some of those profits back to the U.S., fairness dictates they should not have to pay the differential with U.S. corporate taxes. (This puts me in the opposite direction of current policy trends.)

But Samuelson fails to address one other potential fact pattern.

Example 2. The American MNC has its major Asia operations in (mainland) China yet invoices its clients out of Hong Kong, paying the lower Hong Kong tax and ensuring that its PRC subsidiary will never have significant profits on its books. (This could be done, for example, through intra-company service agreements, as long as there are no egregious transfer pricing shenanigans.)

Any problems with this? Any accountant, lawyer or business person will say absolutely not, this is good financial management. True.

But is this "fair"? To the extent that, through the use of lower tax jurisdictions, a company can park profits there and avoid the taxes that they would have been subject to had they reflected those profits on the books of the entity adding the real value, I think that is kinda iffy from a fairness standpoint.

So what about the Obama proposals? Complete crap, really. All they would do is go after companies that currently defer tax on overseas profits. A lot of countries do not tax overseas profits at all, so the U.S. could end up being an outlier on this area of tax law some day, which is not a good thing for U.S. competitiveness.

Solution? Funny how it all comes down to international cooperation these days, doesn't it? Look, as long as you have tax havens, companies are going to take advantage of them, and it isn't really fair in the grand scheme of things. And as long as tax havens exist and countries are (legitimately) worried about attracting/retaining MNCs onshore, there will be a race to the bottom with respect to tax policy. The current Obama proposals are a blip, a speed bump on that spiraling road down to the bottom. Anyway, I assume that whatever new rules may be put into place will include sufficient loopholes to make them meaningless anyway.

The obvious solution is that you need international consensus on getting rid of tax havens. I didn't say it was going to be easy, but it does seem to be the only real way to fix the problem long term, doesn't it?

Tags: China Business & Economy, Obama Administration, tax havens, tax law