By Alex M. Parker, Principal, Capitol Counsel LLC, Washington, D.C.
The most recent version of Democrats’ plan for overhauling the US tax code – approved by the House Ways and Means committee on September 15 – suggests the party may be backing down on its promise to repeal a key part of the Tax Cuts and Jobs Act’s international framework. The law’s tax exemption for foreign tangible property is safe, for now, due in part to global pressure and concerns about American competitiveness.
During the 2020 campaign, in an environment of angry populism and “America First” rhetoric, then-candidate Joe Biden blamed the exemption, part of the tax on global intangible low-taxed income, for the loss of American jobs. It was a “tax loophole that actually rewards companies for shipping jobs and profits overseas,” Biden said.
He was echoing criticisms that Democrats have made since before the law was even passed – that by granting favorable tax treatment to overseas tangible property, the law tilted the playing field away from domestic manufacturing and production, and towards foreign investment.
And yet, the tangible property exemption to GILTI seems poised to survive. Its durability is due in part to the interaction between Congress and international tax negotiations at the G20, but it also reflects the new direction of global, interconnected tax policy for years to come.
One of the chief goals of the TCJA was to shift the US into a territorial tax system that exempted most foreign income from taxation. But to stop companies from siphoning profits out of the US, the law also included a 10.5% tax on foreign income, which is only half of the overall rate of 21%. The provision, known as the tax on global intangible low-taxed income or GILTI, applies to returns of 10% or greater on depreciable property held offshore. The bill’s authors reasoned that unusually high-profit returns on tangible property must be intangible – derived from assets such as patents or copyrights, which are often used in complex tax structures due to their mobility and high value.
Democrats quickly noted that a company would have less GILTI liability the more tangible property it held offshore, so long as its foreign income remained the same. If that tangible property – what the law calls qualified business asset investment or QBAI – is a facility, it may be connected to jobs. This soon became a central criticism of the bill, which critics claimed contributed to US job losses such as General Motors Co.’s closure of its Lordstown, Ohio, auto plant.
Despite the Democratic criticisms, the GILTI concept proved intriguing to the rest of the world, especially as it dealt with complaints about global tax avoidance. The Organization for Economic Cooperation and Development, a global body that sets international tax norms, included a similar proposal in a package of proposed reforms to address concerns about taxation in the digital economy, requested by the G20 coalition in 2017. In 2020 the new Biden administration promoted the concept as a global minimum tax agreement.
In keeping with its stance on GILTI, the Biden administration pushed for the OECD to adopt a true minimum tax targeting all income. The goal was not only to stop artificial profit-shifting but to end what US Treasury Secretary Janet Yellen called the “race to the bottom” between countries trying to lure real investments with lower and lower tax rates.
The same debate as in the US played out in international debates. But the OECD ultimately settled on a “formulaic substance-based carveout,” which officials said was the only way to ensure that all countries approved the agreement. The carveout is potentially even bigger than QBAI, including payroll as well as tangible assets in the calculation.
The OECD decision made a QBAI repeal a much more difficult proposition – especially given assurances from Yellen and the administration that a global minimum tax agreement would allow the US to raise its corporate rate without risking economic competitiveness. Without an exemption for physical properties, the US global minimum tax would be broader and more onerous than the similar taxes imposed in the rest of the world, raising prospects for corporate inversions or foreign takeovers.
In light of this dynamic, it’s not too surprising that Democrats in the House of Representatives balked and opted for a plan which retains QBAI, although they reduced the exemption to 5% of a company’s foreign depreciable property, instead of 10%. Their version of the legislation, which passed the House Budget Committee on September 25 and is expected to go to the House floor later this week, isn’t necessarily what Congress will ultimately consider. A Senate version eliminates the QBAI exemption completely. But the House plan likely reflects the language with the most consensus among Democrats.
This may seem like a minor tweak. But the change reflects the current direction of global tax policy. Despite US proclamations, the rest of the world isn’t ready to give up tax competition. Instead, countries are prepared to accept only a minimum tax targeted to the intangible income involved in outright tax avoidance. The expansive US vision of harmonizing all corporate tax rates will have to wait, for now, as countries retain the freedom to tax real activities at whatever rate they feel works best for them. Ireland has already said it is exploring dual rates to keep its 12.5% corporate tax rate for domestic companies, taking advantage of the OECD’s substance exemption.
And while Democrats have vowed to equalize foreign and domestic tax rates and tax the profits of US firms wherever they are located, their equal commitment to multilateralism has blocked their desire to pursue full worldwide taxation. In the US, home of a large percentage of the world’s richest companies, worldwide taxation based on residence may be an easy political sell. But the rest of the world remains wary of using residence, a sometimes tricky and arbitrary concept, as the foundation for the tax system.
While Democrats may be close to abandoning hopes of repealing QBAI, they are still pursuing other measures to tighten the reach of GILTI. The House proposal would calculate the GILTI amount on a country-by-country basis, rather than aggregating all foreign income as under current law. Democrats claim that blending allows companies to continue using tax havens, so long as they mix them with higher-tax countries.
But the Democrats’ legislation also would allow companies to carry forward excess foreign tax credits as well as losses for GILTI. The result would be a system that is both more targeted and more flexible and is in keeping with the OECD’s design. According to an initial estimate from the Joint Committee on Taxation, modifications to the GILTI regime, as well as to the deduction on foreign-derived intangible income or FDII, its domestic counterpart, will raise just over USD 200 billion for the next ten years. That’s not a paltry figure, but it makes it a relatively small part of the USD 3.5 trillion infrastructure package, seemingly out of proportion with Democrats’ rhetorical emphasis on alleged corporate tax avoidance.
As for offshoring, what little data academics have collected in the three years since the TCJA’s passage is inconclusive on whether QBAI is really contributing to foreign investment. Defenders of the law note that other factors are likely to outweigh tax considerations when corporations make location decisions. And a country with a corporate tax rate low enough to make a difference may not have the infrastructure or workforce to make an investment profitable.
This is the essence of the territorial tax philosophy – to ensure that the rules on measuring taxable income are fair, and then let the chips fall where they may. While the US may not be fully on board yet, the rest of the world is ready to take the bet.
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