In my last post, I commented generally on the Administration's FY 2011 budget proposals, noting that there is a lot not to like in them, along with some good ideas. This post is an extension of that earlier one.
One of the proposals in the budget is to continue for another year the "active financing" exception to subpart F income that is set out in section 954(h). To translate that from tax-nerdese to everyday talk, let me just say this. That exception means that US financial services firms (including banks, securities dealers/brokers, and finance companies of some manufacturers or other companies that have financial services subsidiaries) get to defer the US income tax on the same kind of income that is taxed currently in the US to other firms as overseas passive earnings (things like rents, interest and dividends).
Banks are very broadly defined--very generally speaking the corporation must be licensed to accept deposits, deposits must be "substantial" and it must make loans and perform at least one banking activity in the country of incorporation. Finance companies can make loans or purchase installment notes, or engage in leasing, or provide related services.
I've said before that I don't think the active financing exception makes sense--certainly not for broker/dealers and financing subsidiaries of manufacturers and probably not even for regular banks. This kind of income is highly fungible and the entites that earn it are highly mobile. Financial products are highly susceptible to manipulation--what we call "financial engineering". And of course, there's no reason for these types of activities to be located abroad, generally, rather than the US, except to take advantage of the active financing exception. So the exception essentially pushes companies to create financing companies abroad and then takes the revenue hit for the fisc. The various rules have holes in addressing these concerns, and those holes are not easy to fix. The definition of finance company is overbroad, and tests based on location of activities don't make sense in an electronic "e-finance" world. Base shifting is not only possible, but probable. Better just not to have the exception,in my view.
The 1986 tax reform, which was a long-term and bipartisan effort to remove the gaping loopholes from the Code in order to broaden the base and be able to lower the rates, repealed a similar "active financing" exception as one of the many loopholes that made no sense. Of course, lobbying was intense, and the banks argued that the drastic step should be transitioned to give them time to adjust to the change. The 1997 Congress granted them their wish and granted a one-year temporary exception. With few exceptions, that has been the pattern ever since. See, e.g., Willens, Will Congress Act to Save Tax Break on Foreign Subs? CFO.com (Aug. 25, 2008) (noting that the active financing exception "has nearly halved the effectve tax rates on some controlled foreign corporations"). Of course, the banks no longer argue that they need a one-year extension so that they can handle the transition to no exception. They instead build the exception into their profit planning, and now argue that it's time to make the exception permanent.
So what are the arguments made in its favor? Proponents of the exception for US MNEs in financing argue that this exception helps "competitiveness" or "fairness", by treating the passive income earned by banks as their "active" income and excepting it from subpart F provisions. Also, they note that pricing takes the active financing exception into account, with the implication that it would be unfair to change the exception for that reason. See, e.g., the Equipment Leasing and Financing Association piece in favor of the active financing exception, here.
As to the first (competitiveness) rationale:
Companies argue that the exception allows US financial companies to compete on a level playing field with their foreign competitors when they go into overseas markets. This is often stated as though it is an inherent good--helping US companies to beat the competition overseas.
Is it? What benefit does the US get from that? Multinationals tend to be much bigger than purely domestic companies, and have much more complicated structures. Is that a benefit or a detriment. Surely, when it comes to banking, we've seen that it is a detriment. It may well be in other areas as well. Companies that are too big lose any sense of belonging to a community, or a nationa, I suspect. They become the perfect example of the "rational man" hypothesis of free marketarianism. We know that man is not really the "homo economicus" that the Chicago School would have have us believe, but corporations come closer to fitting that ideal. Ultimately, the decisions are made by people, but the hierarchical pattern of decision-making and the corporate charter itself favors decisions that look solely to the bottom line rather than to the other things that normally motivate humans--altruism, love for community and country, moral and ethical standards, etc.
What about when the companies that the MNE is competing with are also US MNEs? Just what does the US gain by reducing taxes in that case? Mainly, the same as in other cases--less tax revenue.
Further, if we help big MNEs compete abroad, do we win benefits here at home? If so, what are they? Often, as companies move abroad, they also move their manufacturing bases abroad to be closer to home. Sometimes they manufaccture abroad and import that product back into the States, when previously they manufactured in the States. It seems hard to find a benefit there, when we lose jobs and add environmental degradation (empty manufacturing facilities at home that are often now environmentally damaged sites requiring remediation).
Are we benefited with the "bragging rights" of having large US companies create new markets abroad? How about when those companies become the symbol for pseudo-colonial practices that wreak havoc on native communities (the U.S. Fruit Co. behavior in the "banana republics" decades ago; the Big Oil behavior in Latin America, the sweat shop clothing manufacturers established by US brands in Cambodia and other southeast Asian countries, etc.)?
Sure, it's a mixed bag. I'm just saying that the "competitiveness" argument certainly isn't so lopsidedly favorable as the MNEs would have us believe when they constantly tout the importance of reducing their taxes so they can be "more competitive" abroad.
As to the second (fairness) rationale:
When I've made fairness arguments, people sometimes write me (on the blog, or personally) to say--fairness is in the eyes of the beholder, so fairness arguments aren't any good." I disagree, because I think I have established a sound basis for fairness arguments in tax, resting on two strong foundations--the notion of ability to pay (which supports progressive taxation and equality among different types of income, such as removal of the preferential rate for capital gains) and the notion of democratic sustainability (which supports a tax system that supports rather than impedes the development of sound democratic processes, and thus works against the tendency of our capitalist economy to concentrate resources in the hands of those at the top).
In the corporate context, fairness has many components. As to the relations between workers and managers, fairness exists when companies pay workers a decent wage for a decent day's work, and when the upper management is not paid hundreds of times what ordinary workers are paid. As to the relation between companies and communities, fairness exists when companies don't finangle deals from communities with promises of jobs and then move out leaving empty shells behind, never having delivered on the promises that garnered them huge tax breaks. So what about fairness in the context of a globalized marketplace? Fairness exists when companies do not get unreasonable tax breaks that benefit a particular industry compared to other types of industries.
As to the third (pricing) rationale:
An objection inevitably raised when anyone tries not to extend the active financing exception is that companies have likely built the tax break into their pricing (for example, a multi-year equipment lease may have built the active financing exception into the terms of the lease, since the tax break means that a company that enjoys the tax break can charge slightly less). Those companies don't like the idea of making less money than they might have made, if they had raised their lease charges because of expecting the exception might vanish. But that's just a fact of life in a world where taxes are a given. We can't accurately predict what future tax rates will be, any more than we can accurately predict what kind of unusual event will affect the business or what new inventions might lead to a rapid change in a business. Businesses manage by trying to plan ahead, build appropriate cushions, and respond in timely fashion to the markets and other factors affecting their profits, including taxes. The answer, then to the "expectations" complaint is essentially "sorry, but this is what reasonable tax policy should be."
PS: look again at the CFO.com article. Note that (in fall 2008) it reported that GE's effective tax rate for 2007 was only 15.5%, even though the statutory rate was 35%. Two things worth noting here.
1) You see why I have argued that the Tax Foundation is engaging in propaganda rather than dissemination of information when it complains that the US has a "high" corporate tax rate--if you only look at the statutory rate, you do not see the whole picture at all.
2) The article notes that these "lower-taxed earnings are designated as 'indefinitely invested' outside the United States". The article's point is that the financial accounting benefit provides high profits to GE that it keeps out of the country, and that it would be truly lamentable if GE lost its ability to continue to enjoy these low-taxed profits. But note that the statement means that those earnings--and our lower taxation of them--do nothing to benefit the US. They are reinvested abroad, not growing jobs at home. Why should our tax policy be intended to help US MNEs gain such low-taxed earnings if they aren't brought home to reinvest here?