People are full of ideas about how to reform the U.S. tax code. Some proposals are narrow in scope and targeted to address a specific problem. Others are grandiose in their ambitions and threaten to alter key aspects of our tax regime. And sometimes a tax reform idea begins quite small, only to grow more substantial with the passage of time — a bit like a snowball rolling downhill. History may show this to be the case with the so-called haircut provision of the Tax Cuts and Jobs Act. As a whole, the TCJA is such a complicated piece of legislation that, even 18 months after its December 2017 enactment, taxpayers and their advisers are still coming to grips with it.
Just to be clear: We’re not talking about literal haircuts. That would be a bizarre way for Congress to raise money. The figurative haircut refers to a strange new limitation on some foreign tax credits that was created under the TCJA.
The TCJA took a varied, almost indecisive approach to taxing foreign profits. It includes a participation exemption that’s intended to exclude qualifying foreign profits from the domestic tax base, which is what commentators are referencing when they allude to the TCJA establishing a “territorial” corporate regime. However, the law also includes a special minimum tax on some foreign profits that are (in theory) derived from intangible assets held offshore. The tax is known by its clever acronym: GILTI (that is, global intangible low-taxed income). GILTI takes back some of the benefits of the participation exemption.
Here’s the kicker: Often these foreign profits were already taxed by the government of the jurisdiction in which they were earned. The tax code normally permits the affected U.S. taxpayer to claim a dollar-for-dollar tax credit in the amount of the foreign taxes paid on the relevant pool of income. If you already paid €100 in taxes on foreign profits that wind up in your gross income for U.S. tax purposes, you typically get an FTC for the same amount (once you convert euros to dollars).
That’s basic stuff. But the haircut throws us a curveball. For GILTI inclusions under the TCJA, the taxpayer’s FTC is limited to four-fifths of the foreign tax paid. That’s 80 cents on the dollar.
The haircut serves two distinct purposes. First, it helps raise a bit of extra revenue to defray the costs of the TCJA, which exceeded a trillion dollars. Obviously, the IRS can collect more money if U.S. corporate taxpayers offset their GILTI inclusions by 80 percent of foreign taxes paid instead of the usual 100 percent.
Second, a growing population of economists have become big fans of the haircut on policy grounds for reasons that have nothing to do with the IRS collecting more tax revenue. Under prior law, with a 100 percent FTC, taxpayers could sometimes grow ambivalent about whether they had to pay foreign taxes. It’s as if they didn’t have skin in the game. Sure, they’d be obliged to pay the foreign tax, but they’d get the entire payment back in the form of reduced U.S. tax liability via the FTC.
Here’s what’s troubling about that scenario: It involves an implied subsidy of the foreign government at the U.S. government’s expense. Granting a 100 percent FTC is the economic equivalent of the U.S. Treasury transferring funds — in the amount of the credit — to the foreign country. Obviously, it’s not a direct payment, but a series of sequential occurrences, collectively, result in a subsidy. The IRS collects fewer tax dollars, so the U.S. government is made worse off. The foreign tax authorities collect more tax, so they’re better off. And the taxpayer is indifferent.
The striking thing about the haircut provision in the TCJA is that it alters this dynamic. Because the FTC for GILTI inclusions is less than 100 percent, taxpayers have a freshly minted incentive to minimize their foreign tax liability. They can no longer afford to be indifferent: Now, they have skin in the game.
A lot of policymakers have been uncomfortable with U.S. FTC policy for a long time. With the advent of the TCJA, there’s suddenly a path to fundamentally reforming it. The subsidy is difficult to justify now that the U.S. has a nominally territorial tax regime thanks to the aforementioned participation exemption. And, in time, the GILTI haircut will cause taxpayers to grow accustomed to something less than a full 100 percent credit for foreign taxes paid. Like actual haircuts, the new look eventually becomes the new normal.
You can see where this is going. The federal budget deficit grows larger with each passing year. Eventually, Congress will grow desperate for a revenue raiser. Don’t be surprised if one of the first things they turn to is an expansion of the haircut treatment so that it isn’t limited to GILTI inclusions. Instead, all FTCs would be scaled back to just 80 cents on the dollar — or possibly lower, depending on how desperate Congress is for an easy revenue raiser. How does 75 percent sound? Politically, the change could be sold as a form of pragmatic self-interest or, dare I say it, economic nationalism. The argument: Why should U.S. taxpayers subsidize foreign governments?
The downside of the haircut, of course, is that corporate taxpayers will incur double taxation to the extent that their foreign profits are (at least in part) being taxed in two countries. Still, given that corporations just got themselves a rather impressive rate reduction — from 35 percent to 21 percent — those grievances might fall on deaf ears.