If America is serious about reviving its manufacturing base, Congress should shut down what tax experts refer to as the “round-tripping” loophole in our international tax system. This gap in the law encourages U.S. multinational corporations (MNCs) to move both production and profits offshore even when selling to American consumers — at the expense of domestic businesses and workers. It’s a straightforward fix that could bring jobs back home and restore fairness to our tax code.
The perverse tax incentives for U.S. MNCs to first earn, and then keep, profits and manufacturing overseas instead of in the United States drove much of the momentum that led Congress to enact the Tax Cuts and Jobs Act (TCJA) in 2017. The highest corporate tax rate in the Organization for Economic Co-operation and Development (OECD) discouraged U.S. MNCs from earning manufacturing profits in the United States rather than in some low-tax jurisdiction overseas. And a U.S. international tax system that allowed those U.S. MNCs to avoid U.S. tax on foreign profits until those profits were repatriated to the United States discouraged them from bringing the profits back to reinvest here. The result was that U.S. MNCs engaged in all sorts of complex planning to shift their manufacturing to foreign countries and the related profits to tax havens.
To encourage businesses to bring their activity back to the United States, Congress lowered the corporate rate to 21 percent from 35 percent. Congress also enacted a series of international tax reforms, including a “carrot-and-stick” approach to locating intellectual property (IP) and related manufacturing in the United States.
The “carrot” takes the form of a reduced tax rate (currently 13.125 percent) on the above-normal profits (i.e., returns on investment exceeding 10 percent) of U.S. companies derived from sales to consumers for use in foreign markets. These tax rules for “foreign-derived intangible income” (FDII) encourage U.S. MNCs to keep their valuable IP — the kind that leads to above-normal returns — here in America instead of locating it in tax havens. And if the IP is here, then the manufacturing can stay here. Under the U.S. international tax rules, if IP is owned in a foreign subsidiary but used by a U.S. manufacturing affiliate, the U.S. parent company incurs a huge tax penalty. For that reason, once a U.S. MNC moves its IP offshore to escape taxes, its manufacturing almost always follows.
The “stick” takes the form of the world’s first foreign minimum tax, with a minimum rate of 10.5 percent (half of the 21 percent U.S. corporate tax rate) on above-normal profits of the U.S. MNC’s foreign subsidiaries – low enough to allow American companies to remain competitive in foreign markets but high enough to discourage the most aggressive tax haven schemes. These tax rules for “global intangible low-taxed income” (GILTI) ensure that at least some U.S. tax is paid on tax haven profits, whether or not the profits are repatriated to the United States.
The TCJA effectively blocked many of the avenues that corporations used to shift money overseas and avoid U.S. taxes. Before 2017, companies created complex tax arrangements to manipulate profit location artificially, such as corporate inversions and IP migration. The evidence shows that this is more difficult for taxpayers today. Numerous U.S. MNCs, especially in the highly mobile tech sector, responded to the TCJA by repatriating assets to the United States.
But the law isn’t perfect. Some U.S. MNCs can still avoid tax on sales to U.S. customers by locating IP and manufacturing facilities in low-tax jurisdictions. This way, they can claim lower tax rates meant for truly foreign income, even while selling the products back to U.S. consumers.
For example, the “round-tripping” loophole allows U.S. companies to take advantage of the 10.5 percent GILTI tax rate while selling products to U.S. consumers in the U.S. market, by offshoring the manufacturing to a foreign subsidiary located in a tax haven. This loophole costs the U.S. Treasury tens of billions of dollars and could be closed through a simple tweak to the rules.
While it makes sense to tax American companies operating in foreign markets at a reduced rate so they can compete globally with, say, Chinese companies, allowing companies to take advantage of this reduced rate through round-tripping back into the United States just puts Main Street businesses at a competitive disadvantage. When a Main Street business sells its product to American customers, it pays full U.S. tax on those profits. But when a U.S. MNC manufactures offshore and locates its profits in a tax haven before selling to the same American customers, it can pay a U.S. tax rate as low as 10.5 percent.
This strategy is especially prevalent in sectors that combine complex manufacturing chains, where corporations have flexibility on where to locate the final stage of production, with outsized profit-making opportunity in the U.S. (as opposed to foreign) market — such as the U.S. pharmaceutical industry. In 2017 when Congress first created GILTI and FDII, the U.S. pharmaceutical industry argued against closing the round-tripping loophole on the grounds that it would face higher effective tax rates than foreign pharma companies, putting U.S. pharma at a competitive disadvantage.
In other words, U.S. pharma companies argued that a tax benefit for keeping their manufacturing offshore instead of in America was necessary for the industry to compete in the U.S. market!
A new study by accounting professors Michelle Hanlon of the Massachusetts Institute of Technology and Jeffrey Hoopes of the University of North Carolina, however, found that while U.S. and foreign pharmaceutical firms faced nearly identical effective tax rates of 24 percent before 2018, since then U.S. pharmaceutical firms have seen their tax rates drop below 18 percent while those of their foreign competitors’ have “stay[ed] almost constant” — casting serious doubt on the continued claim that U.S. pharma still needs the round-tripping loophole to compete. In addition, because foreign governments are just beginning to impose foreign minimum taxes on their own MNCs pursuant to the OECD Pillar 2 rules – which are even more onerous than the United States’ GILTI rules – foreign pharma’s current 24 percent effective tax rate likely will rise even higher. So, what might have been a plausible argument in 2017 no longer seems to hold much water.
Congress can address the loophole with a simple solution. Restrict the special 10.5 percent GILTI tax rate paid by U.S. MNCs on foreign subsidiary profits to sales into foreign markets, but require foreign subsidiary profits on sales back into the U.S. market (i.e., round-tripping profits) to bear the same 21 percent tax rate paid by domestic companies. The U.S. tax code already distinguishes between “U.S.-derived” and “foreign-derived” profits for purposes of the FDII rules described above, based on where the ultimate consumption or use of the product occurs. Simply limiting the 10.5 percent GILTI tax rate to foreign-derived profits just as the 13.125 percent FDII tax rate is limited levels the playing field. Taxing these U.S.-derived (round-tripped) profits at the full 21 percent corporate tax rate would close the loophole and raise roughly $70 billion over 10 years, according to the Penn Wharton Budget Model.
To be clear, the goal isn’t to punish any particular sector or group of companies, and the proposed solution applies equally to any company in any industry that is exploiting this loophole. Rather than being punitive, closing the round-tripping loophole achieves neutrality, so that economics determine investment decisions without undue distortions from the tax code. Neutrality also ensures that purely domestic companies that keep all of their manufacturing within the United States won’t be at a tax disadvantage.
In an era when re-shoring global supply chains is a top national priority, Congress shouldn’t allow the federal budget deficit to increase by another $70 billion just so U.S. MNCs can be encouraged to manufacture offshore instead of in the United States. Policy ideas to bring manufacturing back to America abound these days, but we should start with the low-hanging fruit of removing tax breaks that encourage the opposite.
