The current structure of U.S. corporate and income tax based on citizenship makes corporations and citizens abroad far less competitive than their counterparts. Here are the reasons
By Kenny Lau
It has been well established in the global business community that both U.S. corporations and individuals are taxed on their worldwide income earned in foreign countries – unlike the residency-based system adopted by most advanced economies countries with which the U.S. competes. It has also been a tax policy making American companies and citizens abroad effectively less competitive than their non-U.S. counterparts around the world.
While the U.K., Canada and Germany generally do not tax corporate revenue repatriated from offshore subsidiaries and certainly do not tax their citizens on foreign earned income, the U.S. is the one exception whereby U.S. corporations are subject not only to a 35-percent tax (one of the highest in the world), but also to taxation on their profits regardless of where such profits are made.
Whenever repatriated income is subject to taxation, corporations are naturally inclined to let profits sit where they are earned or to move them elsewhere through transfer pricing, unless cash is needed to pay out dividends or to make investments in their home country. China, like the U.S., defers taxation until income is repatriated and then allows a tax credit for the underlying foreign tax up to the Chinese tax rate of 25 percent (or 15 percent for high-tech companies).
Chinese companies, like U.S. companies, leave income offshore to avoid paying current income tax, hence a proliferation of intermediate holding companies between Chinese parent companies and their subsidiaries overseas in places such as Hong Kong, Cayman Islands and British Virgin Islands (BVI). Ultimately, taxation on corporate profits abroad discourages reinvestment in the home country, even in a country like China where the corporate tax rate is lower than that of the U.S.
The efficiency of a jurisdiction’s tax system can have a significant influence on the cost structure of companies and dictate the movement of corporate cashflow. It provides a competitive advantage to companies doing business in countries where their ability to utilize cash is not limited by considerations of tax friction. Companies are also much more likely to repatriate and reinvest their capital when foreign earned income is subject to little or no taxation.
In times of much talk in Washington about a potential U.S. tax reform, one shall not underestimate the benefits of a territorial tax system if one of the objectives is to increase the overall U.S. economic competitiveness by expanding the physical presence of U.S. companies in both mature and growing markets around the globe. This is in the best interests of U.S. businesses and, more importantly, of the entire U.S. economy.
The U.S. economy, of course, is far more complex than a tax system; whether one approach over another to taxation (residency-based vs. citizenship-based) is good economic policy is debatable. But there is no question that a territorial (residency-based) tax system allows U.S. businesses to further increase their global market share, expand international sales and drive U.S. exports on the spot in foreign countries.
On an individual basis, Americans overseas play a critical role as unofficial ambassadors of the U.S. representing free trade and private entrepreneurship on a massive scale in a globalized world. The community of U.S. expatriates employed in non-US jurisdictions helps ensure U.S.-made goods and services have commercial viability in the markets across different continents. It plays an instrumental role in U.S. market penetration and influence overseas.
They not only help export their home country’s values, goods and services but also serve the needs of the U.S. economy by participating in government-sponsored programs such as SelectUSA and encouraging foreign direct investment (FDI) into the U.S. This has resulted in large flows of investment from Asia into the U.S. economy, revitalizing depressed areas of the country at a time of budget constraints.
Americans overseas, however, are at a distinct disadvantage because they are subject to U.S. taxation on their income as well as taxation of the country in which they live and work, despite an “inclusion” (tax break) for the first US$101,000 of income under Section 911 of the U.S. tax code. All other advanced countries tax their citizens at effective rates greater than or equal to that of the U.S., but they do not tax their citizens on income earned outside of their home country.
While Section 911 offers a housing allowance exclusion, it is generally insufficient to prevent housing benefits from being included in the tax base of U.S. expats. Given the high cost of living in the Asia Pacific region, Americans living and working abroad have had to endure tax liability and compete with their counterparts from the U.K., Germany, Canada and Australia on a playing field far from being level.
It is more costly when U.S. multinational corporations send their senior executives of U.S. origin than those of other nationality on foreign assignments. Because exclusions under Section 911 are insufficient to offset the additional tax liability of individual employees incurred from citizenship-based taxation, employers find it necessary to equalize by bearing the extra tax costs of overseas assignment.
The current structure of U.S. corporate and income tax based on citizenship is an indisputable cycle undermining the global competitiveness of U.S. companies and expatriates. It is particularly pertinent to Hong Kong where U.S. businesses are regionally headquartered to open markets in Greater China and across Asia Pacific. The possibility of a U.S. system of territorial taxation may be far-fetched; but it could start by increasing substantially the amount of inclusion under Section 911.