June 3, 2009

How About an International Tea Party?

In recent weeks, the President has initiated a drive to root out international tax cheats and collect money due to the Treasury from global sources. On the surface, this looks like a good idea. Let’s collect from those deadbeats and reduce our own tax burden. Nobody wants to be subsidizing companies (and wealthy individuals) who are using global operations to avoid paying their fair share of U.S. income taxes.

Is there any truth in this argument? How will the admittedly early stage proposals impact our industry? Who wins and who loses in the proposed changes?

As I researched international tax factors, I learned that different countries use some very different approaches to taxing overseas earnings. According to the WSJ, many countries, Germany for example, expect their multi-nationals to pay the income tax rate that exists in the particular offshore location. So, for example, if a German company had a business unit in Ireland, where the corporate tax rate is 12.5%, that unit would be expected to pay the Irish rate. Any earnings re-patriated to Germany would not be taxed further.

Another basic approach is to pay the local taxes and use them as deductions against the home country obligations. So, in the case of a U.S. company with a business in Ireland, the company would pay the 12.5 percent Irish rate but would be liable for paying U.S. tax up to the U.S. statutory rate of 35 percent (plus about 4 percent more on average for state taxes according to the Congressional Budget Office). But here’s the rub: If the earnings are kept overseas, the balance of the U.S. amount can be deferred indefinitely until such time that the money is actually sent back to the U.S. The Administration’s proposal would eliminate this deferral and make the U.S. tax due in the current period.

So what are some of the consequences of the proposed change? First, a U.S. company would be put at a competitive disadvantage compared with a similar German company. The Germans would have realized a substantial tax saving. That saving could be applied to any corporate purpose from paying dividends to taking price action locally or at home, to investing in more productive capacity in Ireland or elsewhere. It does not look like a win for the U.S. guys. Now, even under current law, the U.S. company is disadvantaged, but not if they elect to keep the money overseas. So, the Germans have an edge, but it would increase under the new proposals.

What about the propensity to invest overseas? My sense is that the proposal will dampen U.S. firms’ desire to place capacity offshore. If it makes sense to enter a market, they will still do it. However, on the margin, fewer cost-justified deals will calculate out as attractive. Some that might have looked good before won’t make the cut given the change. This would tend to reduce U.S. companies’ international business development versus other countries’ multi-nationals. Ultimately, it would be unfavorable to U.S. interests.

How about U.S. jobs? The new tax proposal will probably have limited impact. If people went offshore for cost improvement, they can still get much of it by buying from a contractor. Jobs might move from the OEM’s plant to a vendor’s plant in the offshore location. Multi-national competitors from other countries will have no negative effect and will be able to sell in the U.S. at the same, presumably low, prices as before. And they might gain market share versus their US competitors. Ironically, the U.S. office functions of the impacted U.S. multi-nationals might see a reduction in jobs due to loss of share, but it is possible their competitors will have to add. It would be a stretch to believe that meaningful numbers of jobs that are economical overseas would come back to the U.S. Maybe a few at the margin will return, but my view is the bulk of them would simply be lost to international competitors.

What about prices for goods back here in the U.S.? Probably another case for limited impact. Unless the particular industries served are fairly concentrated, typical competitive forces should cause prices to maintain similar levels.

With regards to the U.S. Treasury, we may see a short-term gain due to the elimination (or phase-out) of deferrals. Longer term, less revenue would be generated as other countries’ multi-nationals gain share and pay taxes elsewhere. It’s hard to see how this is good for U.S. tax collections over the long-term.

The ultimate result may be a reduction in vertical integration in the electronics business. This is good for overseas CMs and possibly some in the U.S. as the horizon for economical offshore operations comes in a bit. It’s not as good for OEMs because they won’t be able to take advantage of their own offshore investments as much as before.

So why are we considering this? It doesn’t seem to be a major factor from the perspective of tax collections and may put U.S. companies at a long-term disadvantage. It may be a case where outrage is trumping economics.

Should we start boiling water for our tea party?

--Jeff Cosman


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