New Legislation Would Close Significant Offshore Loopholes in the Tax Cuts and Jobs Act

An earlier version of this article was posted in ITEP’s Just Taxes Blog.

The Tax Cuts and Jobs Act (TCJA) was a historic opportunity to reform the international tax code and finally put an end to the rampant shell games played by U.S. companies to avoid taxes. Unfortunately, the TCJA will likely increase offshore tax avoidance and increase the incentives for companies to move jobs and operations offshore. As a new ITEP report explains, TCJA creates many new breaks and loopholes for offshore corporate profits, and while several different bills have been introduced to close them, no one bill addresses all of them.

One simple rule should drive the nation’s international tax policies: tax the offshore profits of American companies the same way their domestic profits are taxed. The latest legislation to approach that ideal is the Per-Country Minimum Act (H.R. 6015), from Rep. Peter DeFazio (D-OR).

The DeFazio bill closes the loophole that allows corporations to use foreign tax credits to shelter profits in tax havens from U.S. taxes. No other bill addresses this.

The United States allows its corporations a foreign tax credit (FTC), which reduces U.S. tax liability on offshore profits by whatever amount a company paid in taxes in the country in which it earned the profits. This makes sense in theory because it prevents double-taxation of profits.

The problem arises when a company has excess FTCs, because, for example, it generated profits in a country with a higher corporate tax rate than the U.S. has. The federal tax law allows the company to use excess FTCs to reduce U.S. taxes on profits from other countries — including tax haven countries with little or no corporate taxes. So, in addition to ensuring that profits are not double taxed, the foreign tax credit is being used to ensure that some profits are not taxed at all. The DeFazio bill would close this loophole.

The Details

To combat the incentive to avoid taxes by shifting profits offshore under the new international tax regime, the TCJA created a type of minimum tax on what the law calls “global intangible low-taxed income” or GILTI. GILTI is defined as foreign income in excess of 10 percent of a company’s offshore tangible assets. The tax on GILTI is unlikely to discourage companies from shifting profits offshore. One problem is that a company can reduce its GILTI by shifting more tangible assets (like machinery) offshore. Another problem is that the tax on GILTI is effectively imposed at a rate of 10.5 percent, just half of the 21 percent rate imposed on domestic profits.

Companies can further reduce their tax liability on GILTI with foreign tax credits generated based on the amount of foreign taxes they have already paid — and this brings us to yet another problem. The tax law allows companies to apply their foreign tax credits on a worldwide basis. This permits companies to reduce their overall tax liability by allowing them to blend profits earned in low- or zero-tax countries with those earned in high-tax countries. For example, under the new system, a company would have an incentive to shift a substantial amount of its earnings into a tax haven (e.g. Bermuda) where it pays zero in taxes if it pays enough taxes in a higher tax country (i.e. Japan) to offset a significant amount of its U.S. tax liability. Ironically, allowing the foreign tax credit on a worldwide basis may encourage companies to invest in high-tax foreign countries because it would allow them to generate larger foreign tax credits.

To fix this loophole created by the TCJA, Rep. DeFazio’s Per-Country Minimum Act would require that the tax rate on GILTI be applied on a per-country basis. In other words, it would not allow foreign tax credits from higher tax countries to reduce taxes on GILTI earned in low- or zero-tax countries. This reform would raise a significant amount of revenue and curtail the incentive to shift profits into tax havens.

In addition to applying the GILTI tax on a per-country basis, Rep. DeFazio’s legislation would address another major weakness in the tax on GILTI by eliminating companies’ ability to deduct 10 percent of their tangible assets before the tax rate on foreign income applies. This change would end the tax incentive created by the deduction to shift real operations offshore and broaden the base of the tax on GILTI. Second, it would raise the effective tax rate on GILTI to 13.125 percent to match the tax rate on foreign derived intangible income (or FDII). While the ideal tax rate on offshore income should be the same as on domestic income, increasing the effective rate on this income from 10.5 percent to 13.125 is a step in the right direction and at least ensures that GILTI is not more tax favored than FDII.

By bringing attention to and showing how to fix the problems in how GILTI is taxed, the Per-Country Minimum Act represents a critical contribution to the debate over how to reform the offshore tax system. Any future tax reform legislation would be incomplete if it did not include this bill’s per-country approach to applying U.S. taxes on foreign profits.

For a deeper dive into the offshore tax system and how to fix it, read our new report The New International Corporate Tax Rules: Problems and Solutions here:

Richard Phillips is the Senior Policy Analyst at the Institute on Taxation and Economic Policy.