Why do US Companies pay so little tax on foreign profits? Does this give them a competitive advantage?

The debate continues as to why US Companies pay such low tax on their non US earnings in the press in Europe. As the following quotes are from an article in the Wall Street Journal on 1 July 2013 show the facts are fairly clear.

“A government watchdog agency found that large , profitable US companies on average paid US federal income tax equalling 12.6% of their worldwide income in 2010.

Taxes paid by profitable companies in the United States are often less than half the statutory 35% tax rate, according to a new study released on Monday by the U.S. Government Accountability Office. The report, which was prepared for Sen. Carl Levin (D., Mich.) and Sen. Tom Coburn, (R., Okla.), found that profitable companies with at least $10 million in revenue, had an average effective federal tax rate of just 13% on their worldwide income in 2010.  The report comes as Sen. Levin, chairman of the Senate’s Permanent Subcommittee on Investigations, has proposed closing some of the tax loopholes he says let companies avoid paying millions of dollars in taxes.

17.4%: Including state and local taxes, this was the average effective tax rate for profitable companies with at least $10 million in revenues in 2010.

16.9%: The effective tax rate for profitable companies has declined in the past few years and companies appear to be paying less tax globally.  Actual taxes paid on corporate worldwide income, including federal, state local and foreign tax expenses and withholding, declined to 16.9% in 2010 from 20.8% in 2008.”

Back in the spring I was asked whether I thought these low US corporate tax rates provided US companies with a competitive advantage in seeking business outside the US. At the time I wasn’t able to answer the question because I hadn’t thought through the issues. After some thought and debate, I feel I can now confirm that the way in which US companies use Outbound tax planning and in particular the Irish non resident company provides them with a significant competitive advantage in competing with non US companies in Europe and elsewhere.

In addition to the quotes above it is clear that generically US companies can achieve tax rates for accounting purposes in the low teens while most European multinationals will have tax rates in the mid to high twenties. Given that they operate in the same markets, why is this?

It seems to me that there are three possible answers:

  1. It could be that European multinationals aren’t as “good” at managing their taxes as US multinationals. I don’t buy this as an argument.
  2. Perhaps US GAAP allows a more beneficial treatment of tax planning than IFRS which applies in Europe. Again I can see no evidence in support of this and no significant difference between the two – it would be rather surprising if there was.
  3. US tax rules for outbound are more liberal than European tax rules. This seems to me to be the nub of the issue. Given their treatment of the Irish non resident company, the US CFC rules are much more liberal than their European counterparts. Some have likened the UK CFC rules to check the box but this is either disingenuous or deliberately misleading.  I question which other CFC regime (outside the US) would not subject to tax income arising  in Bermuda when there are no activities in Bermuda (as is the fact pattern in the Irish non resident company)?

So if the check the box rules provide for a significantly lower level of tax on non US sales how does this impact the competitive balance? Lets suppose that USCO is subject to 2% tax on its European profits and that EUROCO is subject to 25% tax.  If both Cos make profits of 100, then USCO gets earnings (post tax ) of 98 and EUROCO of 75. USCO can afford to reduce its price by up to 20 and still have earnings greater than EUROCO (earnings go down to 78 which is still greater than EUROCO earnings). The US tax rules put it in a position where it can undercut EUROCO in terms of price and still have higher earnings.

Now the US tax rate is irrelevant to this equation as the profits are not remitted to the US for tax purposes. So if I were asked the question again today, does the US outbound tax system give US companies a competitive advantage over non US companies, the answer would be yes and I would expect European governments to do something about it if I was in EUROCO. Oh and if you want to see the 10 biggest users of this planning according to Wiki they helpfully list them in their piece on Irish non resident companies.

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