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Overseas tax shelters and how to get rid of them

Offshore Account

Variously dubbed as “tax havens”, overseas tax shelters offer very low tax rates for businesses and individuals with extremely high income that would be subject to much higher taxes if it were reported in the country they reside in. No universally accepted definition currently exists, but the International Monetary Fund (IMF) defines a tax shelter as a “jurisdiction that provides financial services to nonresidents on a scale incommensurate with domestic economy size and financing”.

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During 2008, the U.S. Government Accountability Office (GAO) was reportedly unable to define “tax haven” satisfactorily but cited five specific features that identify such jurisdictions by:

  1. Zero or nominal income taxes;
  2. Lack of effective tax information exchange with foreign nations;
  3. Nontransparent legislative, legal or administrative tax provision functions;
  4. No significant local presence requirement; and,
  5. Self-promotion as an offshore financial center (OFC).

Likewise, the Organization for Economic Cooperation & Development (OECD) identifies above-listed items #1 and #3 and adds “personal financial data protection” for its Essential Tax Haven Credential Trio.

In 2014, over 358 of the Fortune 500 companies had a subsidiary located in offshore jurisdiction. There have been estimates as to how much cash is currently parked in tax havens, but no one really knows for sure how much money there is. We do know that it’s at least $2 trillion. That’s the number that publicly traded Fortune 500 companies reported as being deferred.

The key for many U.S. corporations to reducing their tax burdens are IRS regulations that provide for income “deferral”.  These regulations let firms delay taxation on profits that they earned overseas. By federal law, U.S. firms may defer taxes on income any foreign subsidiary earns indefinitely, until such profit returns to some domestic venue. The process of returning money to some domestic venue is known as repatriation. When income is repatriated, it is subject to the one of the highest corporate tax rates in the world (39.1 percent in 2014).

The idea behind deferred income tax regulations on offshore profit is that it enhances U.S. competitiveness in global markets by enabling a foreign subsidiary corporation to reinvest liquid capital without attracting extra domestic tax obligation. The expectation is that U.S. firms will increase their capital cost relative to localized foreign competitors and thereby grow faster than otherwise possible.  Deferral is widely cited as especially advantageous for U.S. corporations with operations based in foreign nations with very low marginal tax rates. In other words, if a U.S. company does business in another country, why should they have to pay extremely high U.S. corporate tax rates if they are just going to reinvest the money they earned back into the other country they operate in?

The problem is that deferral regulations create a strong incentive for domestic corporate entities to avoid high U.S. corporate taxes by keeping profits and assets in overseas tax havens. A 2015 report estimated that major U.S. corporations were avoiding $90 billion in federal income taxes each year by using overseas tax shelters.

Another common tactic is “inversion” whereby a domestic corporation acquires an existing foreign company and then claims that the newly merged single entity is offshore by moving their headquarters to the location of the foreign company. This enables reincorporation in a foreign nation that typically has lower corporate income tax rates.  But this maneuver is executed without one cent spent on physical relocation, as the entire process entails creating paper trails as documentation for legal compliance purposes.  Thus, the newly re-emerged entity is still a U.S. firm with the benefits of domestic operation and the tax rates of another country.

So how do we keep U.S. businesses competitive internationally but stop them from using the regulations to hide income?

The simplest solution is to lower the U.S. corporate tax rate. In 2014, the U.S. had the highest corporate tax rate by far of any country in the OECD. Federal and state combined the rate was 39.1 percent versus and average of 24.8 percent for the rest of the countries in the OECD. If we lowered the corporate tax rate in the U.S., businesses would have far less incentive to create subsidiaries to receive lower taxes in other countries.

In 2004, the U.S. instituted a repatriation tax holiday that allowed businesses to return international income to the U.S. and only be taxed 5.25 percent. A total of $362 billion was returned to the U.S. economy. Obviously, the plan was extremely successful at returning international income to the U.S., but how much would have been repatriated if the tax rate were higher?

Most proposals suggest a corporate tax rate between 10 percent and 20 percent. This would make taxes on U.S. businesses some of the lowest in the world which would incentivize corporations to keep their operations in the country.