With the United States imposing one of the highest corporate tax rates of any nation, U.S. companies with overseas subsidiaries face an important decision. They can pay U.S. taxes when they bring cash earned in a foreign subsidiary back to the United States, or they can avoid that tax by permanently reinvesting their earnings abroad.
Many companies, according to MIT Sloan School of Management Professor Michelle Hanlon, choose not to repatriate the money, investing a substantial amount of money overseas.
“This is a big policy issue because the current system encourages companies not only to go overseas but to permanently keep their money there,” she says. “Generally, countries want to attract assets and investments within their borders, but our tax policy does the exact opposite.”
‘Worldwide’ Tax System
Hanlon explains that in the current system in the United States—known as the worldwide tax system— U.S. companies’ earnings are taxed in the United States even if earned overseas. The system does, however, allow companies to defer paying U.S. taxes on the operating income of foreign subsidiaries until they bring cash home to the U.S. parent company.
The taxation of these earnings, she says, also affects financial accounting numbers reported to shareholders. For financial accounting purposes, companies expense taxes paid and accrued. However, companies are not required to record the U.S. tax expense related to overseas operating earnings if the company thinks the earnings will not be repatriated back to the United States.
Both of these effects—the saving of cash taxes and the ability to report a lower income tax expense to shareholders—provide incentives for companies to operate overseas and leave cash there.
Factor in Location Decisions
Hanlon surveyed approximately 600 tax executives and found reducing both U.S. cash taxes and U.S. income tax expense for financial accounting purposes are important factors when corporations decide where to locate and whether to repatriate foreign earnings.
Nearly one-third of the respondents rated the reduction of U.S. income tax expense as important in their choice about whether to locate operations outside of the United States. More than 40 percent reported it as important in their decision to reinvest funds outside of the United States. Those percentages were even higher for publicly traded companies that have foreign assets and high levels of research and development, as nearly two-thirds rated the lower expense reported in financial accounting as an important factor in their decision.
“The implications of our evidence are that both the tax and the financial accounting effects lead to greater foreign direct investment by U.S. companies and lower repatriations,” says Hanlon, noting this research is particularly timely in light of recent talks of corporate tax reform and another repatriation act.
‘United States Has to Reform’
“It’s a complicated issue that companies are spending a lot of time on right now,” she says. “The United States has to reform the corporate tax system in a manner that provides greater incentives to stay in the United States and provides fewer distortions in companies’ decisions to move cash internally. The hope is that this would lead to more companies staying in the United States with greater production and more jobs here as well as decisions based on business reasons rather than tax and accounting benefits,” says Hanlon.
As tax reform is debated, it’s clear the current system creates “terrible” incentives for U.S. companies, she says.
“With such a high tax rate that is triggered any time companies bring foreign earned money back to the United States, they are motivated to continue expanding overseas and indeed to just hold cash overseas. We really need to think about how to tax multinationals while balancing the need for U.S. companies to stay competitive.”
Paul Denning ([email protected]) is director of media relations for the MIT Sloan School of Management in Cambridge, Massachusetts.
