Fight brewing over U.S. offshore profit taxation

WASHINGTON (Reuters) - Large U.S. corporations are pressuring Congress and the White House to exempt overseas corporate profits from taxes, a policy shift that critics say would hurt the economy and increase the federal deficit.

A fight is shaping up between supporters of territorial taxation, as this policy proposal is known, and opponents who favor a different reform -- repealing a tax law that allows corporations to defer paying taxes on their overseas income.

The two sides are facing off over an old and worsening problem -- how to fix the system for taxing companies' foreign income. Both sides agree the system is not working and a new approach is needed, but their solutions are direct opposites.

"A tax system that raises little revenue, but imposes high compliance and administrative burdens on taxpayers and the IRS is the very definition of a bad tax system. Unfortunately, that is the system we have," said Philip West, a former U.S. Treasury Department tax official, at a Senate hearing.

Case in point: business software and hardware giant Oracle Corp. Based in California, Oracle generates 60 percent of its nearly $36 billion in annual sales overseas.

Much of its overseas profit never comes home to the United States, however. Oracle has at least $20 billion in profits parked abroad avoiding taxation, and that is perfectly legal under the overseas income deferral law.

Oracle is a strong supporter of territorial taxation, along with many other Silicon Valley high technology companies, drug makers and other businesses with large foreign operations.

Under territorial taxation, in its strictest form, overseas profits of U.S. companies would be taxed only by the country where they are earned, no longer by the United States.

That would allow companies such as Oracle to bring home their active foreign business income tax-free or nearly so.

This would be a big change because, under present law, foreign profits are supposed to be taxed when they come home at the same 35-percent rate applicable to U.S. domestic profits.

The trouble is that many large multinationals -- like Oracle and others -- do not pay the full tax, or often any U.S. tax at all, on their foreign income.

That is because of the overseas income deferral law, which lets them put off indefinitely the payment of tax on active foreign earnings as long as the earnings remain abroad.

The solution to this problem is not to exempt those earnings permanently from U.S. taxation, say opponents of territorial taxation. Instead, they say, the solution is to repeal the overseas income deferral law.

That would make overseas profits immediately taxable, like domestic profits. And, proponents say, it would lift government revenues, perhaps making room for a corporate tax rate cut.

POSSIBLE SHIFT

The Obama administration is considering a limited version of territorial taxation, although details of its plan are still unclear, The Wall Street Journal reported on Saturday.

Multinational corporations have an estimated $1.5 trillion in profits parked overseas right now, avoiding taxes. They want to be able to bring those profits home tax-free, or with only a small tax hit, and they would like that arrangement to be permanent, as territorial taxation would accomplish.

Such far-reaching reform is unlikely to happen without broad tax reform. That is unlikely to come soon. Congress' "super committee" on deficit reduction, which had its first hearing on Monday, does not have enough time for tax reform and November 2012 elections will make it difficult, analysts said.

The White House's bipartisan Bowles-Simpson deficit reduction panel last year endorsed territorial taxation. Major corporate lobbying groups are banging the drum for it.

The business community is not solidly in favor, however. Multinationals tend to back it. Small and mid-sized companies with less to gain generally are not as enthusiastic.

"I'm a proponent of a territorial system," said Harvard Business School Professor Fritz Foley, citing his concern about other nations, including Japan and Britain, embracing it.

"Having said that, any move to territorial needs to be ... thought through quite carefully," he said.

As for the inevitable political firestorm that would accompany a major push for tax reform, Foley remarked:

"Anything is going to be a tough sell politically, but ... some adults need to stand up and say, here are the trade-offs, here is our fiscal reality, let's think about the best way forward ... My reading of the situation in Washington now is that we're not exactly close to that."

SOME COUNTRIES GO TERRITORIAL

The main argument made in territorial taxation's favor is that everyone is doing it, so the United States should too.

Territorial taxation has been adopted, in one form or another by Canada, France, Germany, the Netherlands, Australia, Switzerland, Japan and Britain. Not adopting it puts the United States at a competitive disadvantage, say its supporters.

"We are so out of step with the rest of the world right now. It is important for us to adopt a territorial system," said University of Michigan Law School Professor James Hines.

Others take a different view.

"I do not agree that we should go to a territorial system," said University of Michigan Law School Professor Reuven Avi-Yonah. "The United States has traditionally been a leader, not a follower, in international tax matters."

Nations that still have a worldwide system of taxation for foreign corporate profits, resembling the U.S. system, include Korea, Chile, Greece, Ireland, Israel and Mexico.

China, Brazil and India, growing economies with thriving manufacturing sectors, also tax the foreign income of their companies much the same way the United States does. "Those are our real competitors," not tax-haven nations, said Avi-Yonah.

A territorial system would prompt U.S. companies to shift offshore even more income than they already do and jobs would follow, worsening unemployment and the economy, critics say.

"Giving corporations a permanent tax exemption for their purported offshore profits will make things much worse. The only real solution is for Congress to do the opposite" and repeal foreign income deferral, said Bob McIntyre, director of Citizens for Tax Justice, a left-leaning tax watchdog group.

(Editing by Howard Goller)