Obama Pushes to Overhaul Silly, Counterproductive U.S. Corporate Tax System

President Obama proposed a big tax hike on American companies. At least in part, Obama's tax plan might actually be good for them.

Obama's proposed tax increases have received a lot of attention in the financial media, but along with the stick, his annual budget submission to Congress contained a big carrot. True, Obama did call for a 14% tax on overseas profits that U.S. companies have not yet repatriated, plus a 19% tax rate on all future overseas income, with a credit for taxes paid overseas. (Obama would use the increased revenue to help pay for greater infrastructure spending.) But the president also included a call to cut the headline corporate tax rate to 28% from 35%. The current statutory U.S. tax rate is the highest in the industrialized world.

Under current U.S. tax law, companies can defer paying taxes on overseas earnings when they state to the IRS that they will permanently reinvest them overseas. Otherwise, the companies owe the taxman as much as a 35% take of money that they bring back to the United States. Bear in mind that companies have typically already paid taxes on these profits in the countries where they were earned.

One might assume that rational tax policy would encourage companies to expand overseas, make lots of money there, and then bring profits back home. But that is exactly the opposite of how the U.S. tax system works: Instead, it rewards companies for reinvesting their profits overseas, while punishing them--via the tax code--for bringing the money back to the U.S. to reinvest domestically or return to shareholders.

If that sounds crazy to you, you're not alone. A lot of countries--pretty much all of them--have reached the same conclusion. To the best of my knowledge, the U.S. is the only economically advanced country in the world that double-taxes repatriated income.

Other advanced nations tend to use what is called a "territorial" system. That is, companies pay tax in the jurisdictions where they earn profits and then are free to bring the money home.

However, countries with territorial tax regimes have suffered from one of the same problems that plague U.S. tax authorities: In both systems, large multinationals have an incentive to shift taxable income to low-tax jurisdictions such as Ireland and the Netherlands. In one popular strategy, companies establish portfolios of intellectual property in low-tax countries and then license the use of that property to their own operations in higher-tax jurisdictions. Effectively, then, these companies are generating tax-deductible expenses in high-tax countries while generating income in places with lower taxes.

In particular, many large technology and pharmaceutical companies use these sophisticated intellectual property tax strategies--along with other loopholes that allow them to "disregard" some foreign earnings for U.S. tax purposes. For example, a

that

There are many problems with the current U.S. tax system. First, because of its high headline rate and double taxation, the U.S. tax code imposes particularly burdensome costs on companies that are not large enough to employ the armies of tax accountants needed to minimize taxes. It therefore puts many U.S. companies at a competitive disadvantage versus their foreign peers. Second, it is a distraction: Many U.S. companies spend a lot of time figuring out how to minimize their taxes--time that would be better spent running their businesses. Third, at present in the U.S., a lot of the country's smartest people are designing ever-more-complex tax-avoidance strategies; from a societal perspective, that's probably not the best use of their time.

Obama's tax proposal has the potential to fix some of these problems. First, by lowering the top corporate tax rate to 28%, the U.S. would have a tax rate that, while far from the lowest in the world, would be more competitive with peer nations'. Second, because all overseas earnings would attract a minimum tax, there would be no special levy for repatriating funds to the U.S. There would also be reduced incentives for companies to engage in some of the most aggressive tax-minimization strategies.

Still, Obama's proposal is far from perfect. The proposal to levy a 14% tax on earnings already held offshore feels a little like changing the rules after much of the game has already been played. That said, many large companies have indicated support for a lower tax on offshore earnings. Perhaps that lower tax rate, combined with a hike in the gas tax--which has not increased since 1993 and has therefore eroded in inflation-adjusted terms--could fund higher infrastructure spending, which has bipartisan support.

Congressional Republicans have mentioned tax reform as an area of potential cooperation with Obama, so it is at least possible that a deal will be reached in 2015. Still, although investors should be mindful of potential winners and losers from comprehensive tax reform, it is too soon to make portfolio adjustments in anticipation of it.

Morningstar's director of healthcare equity research and equity strategy, Damien Conover, who covers a number of pharmaceutical firms that use sophisticated tax-management strategies, said that Obama's proposal will not prompt any immediate changes to his fair value estimates for drugmakers. At this point, Obama's plans are fairly general and enactment-uncertain--and with tax rules, "the devil is in the details," according to Conover.

Still, based on the bare-bones details available, it appears that Obama's proposal could shift some of the tax burden away from purely domestic firms and onto large global companies. As such, Conover said that, if enacted, Obama's proposals "could hurt valuations on multinational companies."

Barbara Noverini, Morningstar's equity analyst covering GE, says that she will also take a wait-and-see approach to assessing various tax-reform proposals. Noverini points out that, during past government attempts to clamp down on multinationals' tax-management strategies, GE's skilled tax team has found ways to minimize the burden on the company. Moreover, even if GE's tax burden rises, to the extent that infrastructure spending increases, GE could benefit from increased domestic revenue and earnings.

At this point, then, investors' best move is to monitor progress toward a comprehensive tax-reform deal--and then as any bipartisan negotiations unfold, determine which firms will be net winners and losers.

The U.S. currently has a corporate tax system that features high rates, tremendous complexity, and inequitable tax burdens based on company size--and it does not raise a commensurate amount of money. Put simply, it is the worst of all worlds. It would be a shame if the president and Congress miss this opportunity to design a simpler, fairer corporate tax system.