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A “territorial” tax system – in which overseas profits of U.S. corporations would be lightly taxed in the U.S. or not taxed at all – is likely to be the top tax reform proposal advocated by Apple CEO Tim Cook when he testifies before the Senate on Tuesday.
Apple – like hundreds of other high-tech and pharmaceutical companies that enjoy enormous profits from royalties or licensing agreements – is able to attribute these profits to offshore subsidiaries located in low-tax havens like Bermuda or the Cayman Islands even when sales revenue and profits are earned primarily in the U.S.
Under current law, these companies continue to owe taxes to the U.S. Treasury on these overseas earnings, as technically, the taxes have only been deferred. But the taxes don’t come due until the profits are repatriated – that is, brought back to the U.S. parent company. A territorial tax system would let these companies repatriate profits without paying the U.S. taxes they owe.
The argument in favor of allowing companies to repatriate offshore profits while paying no tax or a small tax in the U.S. is that corporations will put these funds to work here at home. The promised payoff is increased investment, increased employment and increased economic growth. There is good reason to be skeptical of this promise.
The U.S. tried just such a tax break in 2004, declaring a temporary tax holiday for offshore profits. According to a report by the non-partisan Congressional Research Service, approximately one-third of offshore profits were repatriated in the following year. Academic studies, however, found no evidence that companies used the repatriated profits to increase investment or employment and no evidence that they increased economic activity.
Instead, they freed up other funds that these companies used for stock buybacks and to pay dividends to corporate shareholders. Indeed, many of the companies that benefited from the tax holiday on offshore profits actually reduced employment in the U.S.
It is also a myth that these profits are languishing in offshore in low-tax jurisdictions. According to the Wall Street Journal, a lot of this cash is actually held in U.S. banks or invested in U.S. government and corporate securities. As long as these profits don’t come back to the parent company, they are not taxed in the U.S. But this cash is already at work in the U.S. economy – which undermines the argument that a territorial tax system would bring huge hoards of cash back for investment. The only thing companies can’t do with these funds is reward shareholders.
U.S. companies are supposed to account for offshore profits by setting aside funds to cover future tax liabilities when these profits are repatriated. Few companies actually do this. Most simply declare that the funds have been permanently invested overseas, which frees them from this obligation. Google, Oracle, Microsoft and numerous other companies have taken this route. As a result, these highly profitable companies owe very little in corporate income taxes.
Apple, which currently has $102.3 billion in offshore profits, has not taken advantage of this provision. Its accounts show that it has set aside billions of dollars to cover future tax liabilities on offshore profits. According to the Financial Times, Apple set aside $5.8 billion last year, 70 percent of its reported tax liability, for this purpose. This boosted Apple’s apparent corporate tax rate to 25.2 percent – far above Google, Microsoft and others – and spared the company the public outrage directed at highly profitable companies that pay little or no corporate income taxes. However, the $5.8 billion is an accounting entry that had no effect on the actual taxes Apple paid.
A territorial tax system would further increase incentives to locate jobs in low-tax countries, as profits earned in these countries could more easily flow back to U.S. shareholders. A better solution is to eliminate deferral of taxes on profits stashed offshore and, instead, to allocate taxes on profits based on its activity in various jurisdictions.
About half of U.S. states that have a corporate income tax use such a method for U.S. companies that operate in multiple states. Earlier this year, California adopted a sales-based corporate tax system that taxes companies that sell products or services in California, no matter where in the world they are located, based on the proportion of their total sales revenue generated in the state. This could serve as an example for tax reform that is both simple and fair.
Eileen Appelbaum is a senior economist at the Center for Economic and Policy Research.
This article originally appeared on Economic Intelligence.