J. Clifton Fleming Jr. is the Ernest L. Wilkinson Chair and professor of law at the J. Reuben Clark Law School of Brigham Young University, Robert J. Peroni is the Fondren Foundation Centennial Chair for Faculty Excellence and a professor of law at the University of Texas School of Law, and Stephen E. Shay is the Paulus Endowment Senior Tax Fellow at Boston College Law School. The authors thank Reuven Avi-Yonah, Jim Repetti, Gladriel Shobe, Jarrod Shobe, and participants in a presentation at the Law and Society Association’s June 2024 annual meeting in Denver for their comments on earlier drafts of this article.
In this article, the authors explain how the subpart F regime and the global intangible low-taxed income regime together contribute to a long-running decline in domestic manufacturing employment, and they argue that the best approach to fixing the problem is worldwide taxation without deferral, not pillar 2.
Copyright 2024 J. Clifton Fleming Jr., Robert J. Peroni, and Stephen E. Shay.
All rights reserved.
I. Introduction
The U.S. international tax system has a strong regime for discouraging U.S. corporations from locating passive-income-generating investments in low-tax foreign countries instead of the United States. Those familiar provisions can be contrasted with problematic U.S tax mechanisms that not only fail to produce tax-neutral treatment of locating manufacturing activity in the United States versus in low-tax foreign countries, but actually (and, in our view, inappropriately) favor the latter. The loss of U.S. manufacturing jobs over the past 20 years raises concerns about whether this U.S. tax policy is sensible. The U.S. international tax system should be modified so that its response to the shifting of manufacturing activity and related employment to low-tax countries is consistent with its discouragement of passive income shifting.
II. Discouraging Shifting: Passive-Income-Generating Investments
The U.S. international tax regime taxes U.S. corporations on their worldwide incomes, but it generally treats foreign corporations as taxpayers that are separate from their U.S. shareholders.1 Thus, before subpart F was enacted, the primary method for U.S. corporations to shift passive income from the United States to low-tax countries was to transfer passive-income-generating assets to a foreign subsidiary — that is, a controlled foreign corporation — that was incorporated in a low-tax jurisdiction. Subpart F was in part adopted to counter this strategy.2
Speaking generally, the foreign personal holding company income component of subpart F is designed to impose a current U.S. income tax, at regular rates, on passive income earned by a CFC that is owned by a U.S. corporation.3 That aspect of the U.S. international tax system works reasonably well in substantially discouraging the transfer of passive-income-generating assets to CFCs for the purpose of producing low-taxed passive income that avoids a current U.S. tax.
III. Incentives for Shifting: Manufacturing Activity
A. U.S. Corporations
Subpart F purports to also address the shifting of active business income. Thus, the foreign base company sales income component of subpart F imposes current U.S. tax, at regular rates, on a CFC’s active income from personal property sales, but only if specified requirements are met.4 When it applies, this component is designed to complement subpart F’s foreign personal holding company income provisions in cases of CFC personal property sales income that “has been separated from manufacturing activities of a related corporation merely to obtain a lower rate of tax for the sales income.”5 That appears to provide a straightforward barrier to the strategy of transferring manufacturing assets to a low-taxed CFC for use in generating manufacturing income that avoids a current U.S. tax, at least if the specified requirements are met.
But that barrier was significantly compromised by reg. section 1.954-3(a)(4)(i), which states: “Foreign base company sales income does not include income of a controlled foreign corporation derived in connection with the sale of personal property manufactured, produced, or constructed by such corporation.”6 That language applies regardless of where outside the United States the manufacturing or sales occur, and no other part of subpart F imposes a current U.S. tax on this type of income. Thus, subpart F is no tax barrier to a U.S. parent corporation’s transfer of manufacturing assets, and related jobs, to a CFC for use in producing low-foreign-taxed manufacturing income that avoids a current U.S. tax.7
Thus, subpart F subjects CFC passive investment income to strong current U.S. taxation while active manufacturing income is largely protected from that taxation. Stated differently, subpart F substantially constrains the placing of passive-income-producing assets in low-tax foreign jurisdictions instead of the United States while providing a clear opening for U.S. corporations to invest in manufacturing — and related jobs — outside the United States in low-tax countries (or countries with tax incentives).8
Some commentators have suggested that subpart F’s more favorable treatment of manufacturing operations in foreign countries represents a congressional judgment that locating those operations abroad for tax reasons is less objectionable than doing the same for activities other than manufacturing.9 If that is the congressional purpose, we disagree. From an employment standpoint, the manufacturing scenario should be as concerning as the activities covered by subpart F because the manufacturing scenario contributes to substantial numbers of U.S. jobs being lost.
The global intangible low-taxed income regime was included in the Tax Cuts and Jobs Act to impose a current U.S. tax (at a reduced effective rate for U.S. corporations) on foreign manufacturing income that escapes the subpart F regime, thereby lessening the stark difference in the tax treatment of a CFC’s passive investment income and its manufacturing income.10 The regime does, indeed, reach CFC manufacturing income if it is included in GILTI,11 which is most of a CFC’s foreign-source income that is tested income.12
For simplification purposes, we will describe tested income in the context of a U.S. corporation that has one or more wholly owned CFCs. In that context, CFC tested income includes manufacturing income that is neither U.S. trade or business income nor foreign-source income bearing an effective foreign income tax rate exceeding 18.9 percent.13 However, GILTI includes tested income only to the extent that it is net tested income (that is, the aggregate tested income of the U.S. parent corporation’s CFCs in excess of the aggregate deductions properly allocated to those CFCs).14
And most importantly, GILTI includes only the portion of net tested income that exceeds an exemption equal to 10 percent of the U.S. parent corporation’s profitable wholly owned CFCs’ investment in tangible depreciable business property used in the production of tested income.15 This 10 percent amount is referred to in the code as the net deemed tangible income return (NDTIR).16 The U.S. income tax rate on the NDTIR of a 10-percent-or-more U.S. corporate shareholder of a CFC is zero because of the section 245A dividends received deduction. A U.S. corporation’s GILTI that exceeds its NDTIR bears an effective U.S. income tax rate of 10.5 percent,17 or 50 percent of the normal 21 percent U.S. corporate income tax rate.18
Thus, a U.S. corporation engaged in producing goods for sale in the United States19 and facing the choice of building or expanding a manufacturing facility at home or in a low-tax foreign country will be choosing between a 21 percent U.S. rate on U.S. manufacturing profits and a zero rate on the manufacturing income of its low-foreign-taxed CFC that does not exceed the CFC’s NDTIR, coupled with a U.S. rate of only 10.5 percent on the CFC’s manufacturing income that exceeds its NDTIR.20 That combination provides a powerful tax incentive for U.S. corporations to invest heavily in low-taxed foreign manufacturing CFCs, maximizing its zero-taxed NDTIR and 10.5-percent-taxed manufacturing income that exceeds its NDTIR.21
To the extent that U.S. corporations respond to that incentive by relocating or initiating manufacturing operations in low-tax foreign countries (including in Ireland, Mexico, and Singapore), they create manufacturing jobs in those foreign countries instead of in the United States.
B. Foreign Corporations
The U.S. international tax regime also encourages foreign manufacturers that wish to sell manufactured goods on the U.S. market to favor manufacturing the goods in low-tax foreign countries instead of manufacturing the goods in the United States and thereby creating manufacturing employment there.
For example, assume that Forco, a corporate resident of a country that has not entered into an income tax treaty with the United States (nontreaty country), owns U.S. patent rights to Gizmos, a popular high-tech consumer product that Forco wishes to sell on the U.S. market. Forco has no other U.S. business. If Forco manufactures Gizmos through either a U.S. branch or U.S. subsidiary, the U.S. sales profits will bear a 21 percent U.S. corporate tax.22
If, however, Forco contracts to have an unrelated foreign manufacturer make Gizmos for sale to Forco under terms that make Forco a purchaser instead of a manufacturer for U.S. tax purposes, and if Forco sells the purchased Gizmos to U.S. wholesalers and retailers without carrying on a U.S. trade or business (perhaps by online orders solicited through internet advertising and product delivery by common carriers), Forco’s profits from sales to U.S. buyers will be free of U.S. income tax. U.S. buyers will be customers of Forco instead of its sales agents.23 The same conclusion would apply even if Forco did the foreign manufacturing itself because it would still lack a U.S. trade or business. Moreover, its U.S. sales profits would be foreign-source income, regardless of where it passes title to the Gizmos to the U.S. buyers, because it manufactured the Gizmos abroad.24
If, in the preceding example involving purchased goods, Forco engaged in more aggressive sales tactics by sending traveling sales employees into the United States to call on buyers and solicit orders (with right, title, and interest in the goods passing to the U.S. buyers outside the United States), Forco’s U.S. sales profits would continue to be free of U.S. income tax despite its U.S. business activity because the profits would be foreign-source income25 and Forco would have no U.S. office or other fixed place of business.26
Suppose that Forco instead decided to do its own manufacturing in a low-tax, low-wage foreign country and aggressively sell Gizmos by means of one or more U.S. offices. In that case, 50 percent of Forco’s U.S. sales profits would be foreign-source income and not subject to U.S. tax, thus still providing Forco with a significant tax incentive to manufacture Gizmos abroad in a low-tax foreign country.27
C. Treaty Shopping
In the preceding examples, the U.S. international tax system provides a generous menu of options that offers incentives to foreign corporations wishing to sell goods on the U.S. market to locate the related manufacturing in foreign countries with low-tax regimes instead of in the United States. That theme is also present in U.S. tax treaty policy. Of the 193 member countries of the United Nations, the United States has income tax treaties with fewer than 70, and some of these treaties are less favorable than others to treaty partner residents.28
Unsurprisingly, a resident of a nontreaty country or of a country with a less favorable treaty would be attracted to strategies that allow it to enjoy the benefits of a favorable treaty between the United States and a low-tax country of which it is not a resident. One classic strategy involves a resident of a nontreaty or unfavorable treaty country establishing a corporation in a favorable U.S. treaty country where local tax can be minimized and using that corporation to engage in a business or investment for which favorable treaty benefits are claimed.29 That and other strategies are lumped under the heading “treaty shopping.”
The United States has used multiple approaches to counteract treaty shopping.30 Perhaps the most important of these approaches is the U.S. practice of including a limitation on benefits provision in its modern tax treaties. The most recent articulation of U.S. policy regarding this matter is the LOB provision contained in article 22 of the 2016 U.S. model income tax convention.31
Article 22 states that a corporation formed under the laws of a U.S. treaty partner country will not be considered entitled to treaty benefits unless the corporation is a “qualified person.”32 This article generally provides that a non-publicly-traded corporation is not a qualified person unless its stock is substantially owned by residents of the treaty partner country33 or by no more than five publicly traded corporations whose principal class of shares is primarily publicly traded in the treaty partner country or whose headquarters are located in the treaty partner country.34 This would seem to effectively prevent a corporate resident of a nontreaty or unfavorable treaty country from getting the benefits of a favorable treaty by conducting manufacturing operations through a wholly owned subsidiary formed under the laws of a country that has a favorable treaty with the United States. This conclusion is vitiated, however, by the U.S. model treaty’s active business exception, which reads as follows:
A resident of a Contracting State shall be entitled to benefits under this Convention with respect to an item of income derived from the other Contracting State, regardless of whether the resident is a qualified person, if the resident is engaged in the active conduct of a trade or business in the first-mentioned Contracting State, and the income derived from the other Contracting State emanates from, or is incidental to, that trade or business. For purposes of this Article, the term “active conduct of a trade or business” shall not include the following activities or any combination thereof:
i) operating as a holding company;
ii) providing overall supervision or administration of a group of companies;
iii) providing group financing (including cash pooling); or
iv) making or managing investments, unless these activities are carried on by a bank, insurance company, or registered securities dealer in the ordinary course of its business as such.35 [Emphasis added.]
Because of this exception, the LOB provision in the 2016 U.S. model treaty is effective when a corporate resident of a country lacking a favorable treaty with the United States attempts to obtain treaty benefits by establishing a passive investment within a subsidiary resident in a low-tax country that has a favorable U.S. treaty. However, the effectiveness of the LOB provision is minimal if the subsidiary is used to engage in manufacturing goods for sale on the U.S. market. Thus, when a foreign manufacturing corporation that is a resident of a country lacking a favorable U.S. treaty wishes to sell its goods on the U.S. market and is choosing between a 21-percent-taxed U.S. factory (and U.S. jobs) and a factory owned and operated by a subsidiary in a tax-friendly foreign country that has a favorable U.S. treaty, the active business exception in the U.S. LOB provision encourages the foreign manufacturer to choose the latter. That is because the 21 percent U.S. tax that would be imposed on the profits of a U.S. subsidiary or U.S. branch is avoided if the low-taxed foreign subsidiary does no more regarding the United States than deliver the goods to U.S. customers by common carrier.36
IV. What’s the Problem?
The above-described U.S. tax incentives provided to both domestic and foreign manufacturers for locating manufacturing activity in low-tax foreign countries are problematic because “in the first two decades of the 21st century, the United States lost more than a quarter of all domestic manufacturing jobs, a decline of about 5 million.”37 An alternative formulation states that “total manufacturing employment has decreased by 31 percent between 1998-2019.”38 And yet another report states that “at its peak in June 1979, manufacturing employment represented 22 percent of total non-farm employment, but that share had fallen to 9 percent by June 2019.”39 The U.S. government has recently taken legislative action to stimulate manufacturing employment,40 but the number of workers employed in this sector remains far below earlier levels,41 and the prospects for a near-term increase are dim.42
Of course, the decline in U.S. manufacturing employment has been accompanied by an increase in U.S. service sector employment, so the observation has been made that lost manufacturing jobs are being replaced by service jobs.43 That phenomenon does not eliminate concern, however, because there is no clear evidence that the new service jobs, on average, provide compensation at least equal to that of the manufacturing jobs they are replacing.44 Indeed, there is a belief among policymakers that “manufacturing jobs frequently provide better pay, more consistent hours and stronger worker protections than retail or other service industries.”45
And even if lost manufacturing jobs were being replaced by service jobs that were qualitatively equal in all respects, the debt-burdened United States would still have to deal with why it should forgo revenue — through the tax system features described above — to incentivize the shift from manufacturing employment to service sector employment.46 An affirmative answer to that question is not obvious.
V. Causation Versus Expenditure Policy
To what extent have the U.S. manufacturing job losses resulted from the income tax system’s features described above? That complex causation question is outside our competence,47 and we are not attempting to provide an answer.48 Instead, the position we take in this article is simply that because the United States is facing large fiscal deficits for as far as the eye can see,49 it makes no sense for the United States to forgo revenue through tax expenditures50 that effectively provide a systemic preference for foreign manufacturing and related employment when the benefits to the United States from that preference are doubtful at best.51
To further clarify our position, we are not discussing the fraught issue of whether tax incentives are cost-effective devices for creating manufacturing jobs.52 Instead, our contention is that the U.S. international tax regime uses tax expenditures that have the effect of supporting reduced U.S. manufacturing employment — an indefensible approach in the light of the U.S. fiscal condition.
VI. The Way Forward
We have identified several components of the U.S. international income tax system that encourage both U.S. and foreign corporations to locate manufacturing operations, and related jobs, in low-tax foreign countries instead of in the United States. Aside from the mere problem of politics, corrections for the largest of those flaws are not difficult to conceive.
The GILTI regime encourages U.S. corporations to conduct manufacturing operations through CFCs in low-tax countries because every $1,000 invested in a CFC’s tangible depreciable manufacturing assets increases the CFC’s NDTIR by $100, that is a subtraction from tested income for purposes of calculating GILTI. That subtraction then converts $100 of CFC profit — which would otherwise be taxed at 10.5 percent, less a foreign tax credit — into zero taxed dollars. The cure for that distorting effect is to eliminate the deduction for NDTIR.
But even when that step is taken, the fact remains that manufacturing profits earned by low-taxed CFCs would bear only a 10.5 percent pre-FTC U.S. levy, whereas corporate manufacturing profits earned in the United States are taxed at 21 percent. Thus, a GILTI regime from which the NDTIR deduction is removed would still provide an incentive for U.S. corporations to locate manufacturing operations in foreign countries as long as they can achieve a foreign effective tax rate sufficiently below 21 percent to warrant the transaction costs of the associated planning.53 The cure for that distortion is to raise the U.S. pre-FTC tax rate on GILTI to the normal U.S. corporate rate of 21 percent54 by repealing the section 250 deduction, at least insofar as it applies to GILTI inclusions of U.S. corporations.55
We have discussed how foreign corporations can sell foreign-manufactured goods into the United States without paying U.S. tax on their profits if they do no more than solicit online orders through internet advertising and then make deliveries by common carrier to U.S. buyers. This approach is free of U.S. income tax because it does not amount to carrying on a trade or business in the United States. We have also identified situations in which foreign manufacturers can sell their goods on the U.S. market without paying U.S. tax on their profits by avoiding the use of a U.S. office or other fixed place of business and by managing the U.S. source rules so that their profits are characterized as foreign source. Finally, we have identified an issue in the U.S. model treaty LOB provision regarding active business operations.
Those points all involve the question of the extent to which the United States should tax profits from inbound sales. We believe that the United States is overly passive in this area and should be more assertive by engaging in a review and possible revision of the U.S. trade or business concept, source rules, and treaty policy. That, however, is an ambitious project, and so we will reserve this topic for a future in-depth critique of U.S. inbound taxation.
VII. Conclusion
This article focuses on manufacturing income earned by U.S. multinational corporations through their CFCs because that is the scenario in which most foreign-source manufacturing income is earned by U.S. residents. The GILTI system of taxing that income at rates of zero percent or 10.5 percent, instead of the normal 21 percent U.S. corporate rate, is clearly a costly tax expenditure that encourages U.S. multinationals to either move manufacturing jobs from the United States to low-tax foreign countries or create manufacturing jobs in those countries instead of in the United States. This is unsatisfactory policy in the light of both the long-term decline in U.S. manufacturing employment since 1979 and the slow recovery of that employment even after the job-stimulating provisions of the CHIPS Act and the Inflation Reduction Act. The correct response is for Congress to enact legislation providing that all CFC income bear a current U.S. tax at the regular corporate rate.
We have touched on features of the U.S. international income tax system — including the treaty network — that encourage foreign corporations planning to sell manufactured goods on the U.S. market to locate the related manufacturing facilities outside the United States. Our response to that concerning phenomenon is reserved for a future article.
FOOTNOTES
1 See Robert J. Peroni, Karen B. Brown, and J. Clifton Fleming Jr., Taxation of International Transactions: Materials, Text, and Problems 26 (2021).
2 Subpart F is at sections 951-965. See Peroni, Brown, and Fleming, supra note 1, at 479-484, 490-491. The passive foreign investment company rules also counter such a strategy by passive U.S. investors in a foreign corporation that is not controlled by U.S. shareholders. Id. at 485, 602-603.
3 Section 954(c). Peroni, Brown, and Fleming, supra note 1, at 493, 540-541.
4 Section 954(d). Today the top marginal rates are 37 percent for individuals (for tax years starting before 2026) and 21 percent for corporations. Sections 1, 11.
5 S. Rep. No. 87-1881, at 84 (1962).
6 Reg. section 1.954-3(a)(4)(i). This barrier is further compromised by the various technical requirements of the section 954(d) definition of foreign base company sales income, which reflect the types of abusive transactions in vogue in 1962 but do not reflect current reality.
7 See generally James R. Repetti, “International Tax Policy’s Harm to Manufacturing and National Interests,” 2023 Wisc. L. Rev. 1309 (2023). The regulation can be overridden by a branch exception, which can be avoided with effective tax planning. See Peroni, Brown, and Fleming, supra note 1, at 543. The fallback protection, weak as it was, under pre-2017 law that those untaxed earnings would be fully taxed when invested in the United States or eventually distributed was undermined by partial tax holidays in 2004 and 2017. Section 965. That protection was eliminated starting January 1, 2018, by a 100 percent dividends received deduction that applies to a portion of foreign-source dividends paid by a CFC to a 10-percent-or-more U.S. corporate shareholder. Section 245A. Section 245A does not apply to individual U.S. shareholders even if they make a section 962 election to be taxed as a C corporation for subpart F purposes.
8 Recent research shows that low-taxed profit (meaning profit subject to an effective tax rate of less than 15 percent under the pillar 2 method) is realized by multinational enterprises in all income tax groupings “due to either low baseline [corporate income tax] rates or the presence of tax incentives and other base narrowing provisions.” Felix Hugger, Ana Cinta Gonzáles Cabral, Massimo Bucci, Maria Gesualdo, and Pierce O’Reilly, “The Global Minimum Tax and the Taxation of MNE Profit,” OECD Taxation Working Paper No. 68, at 33 (2024). More than 50 percent of low-taxed profit is realized in jurisdictions that have average ETRs above 15 percent. Id.
9 See Repetti, supra note 7, at 1318; National Foreign Trade Council, 1 The NFTC Foreign Income Project: International Tax Policy for the 21st Century 56 (2001).
10 See Peroni, Brown, and Fleming, supra note 1, at 350.
11 See section 951A(a).
12 See section 951A(b)(1).
13 See section 951A(c)(2). It also does not include whatever manufacturing income is captured under the foreign base company sales income rules of section 954(d), which constitutes subpart F income that is includible in the income of the CFC’s U.S. shareholders under section 951(a). See section 951A(c)(2)(A)(i)(II).
14 See section 951A(c)(2)(A).
15 See section 951A(b)(1).
16 See section 951A(b)(1), (b)(2).
17 Section 250(a)(1)(B) allows a U.S. corporation to deduct 50 percent of its GILTI inclusions (37.5 percent for tax years starting after 2025). This effectively reduces the corporation’s normal 21 percent tax rate to 10.5 percent (13.125 percent for tax years starting after 2025). The section 250 deduction does not apply to a U.S. corporation’s pro rata share of the CFC’s manufacturing income that constitutes foreign base company income under section 954(d) and is includible in its income under section 951(a). The U.S. corporation is subject to tax on that income at a 21 percent flat rate under section 11.
18 See section 11(b). For tax years starting after 2025, the effective U.S. tax rate on GILTI is 13.125 percent after taking into account the reduction in the section 250 deduction from 50 percent to 37.5 percent.
19 A U.S corporation’s production of goods within the United States for sale abroad implicates the foreign-derived intangible income regime (section 250(a)(1)(A)), which is outside the scope of this article. But it is worth noting that “FDII actually provides an incentive for U.S. multinationals to reduce investment in the United States because the deduction for FDII is reduced by 10 percent of qualified domestic tangible assets.” Martin A. Sullivan, “Did FDII Raise Revenue for the U.S. Treasury?” Tax Notes Federal, Sept. 4, 2023, p. 1571. Thus, for this and other reasons, the FDII provisions raise serious tax policy concerns but are outside the scope of this article.
20 This assumes that the CFC’s manufacturing income escapes the reach of the foreign base company sales income provisions in section 954(d), as is usually the case, for the reasons discussed earlier in this article.
21 See Repetti, supra note 7, at 1351, 1353-1354. This incentive is enhanced by the fact that foreign-manufactured goods yield foreign-source income that can increase the foreign tax credit limitation and, if untaxed or taxed at a low foreign tax rate, can be used by the U.S. corporation in cross-crediting tax planning maneuvers. See sections 904(a)(1), 904(d)(1), 865(b), and 863(b) (last sentence); reg. section 1.863-3(c)(1).
22 See sections 882(a)(1) (regarding a branch) and 11(b) (regarding a subsidiary). Assume that no separate royalty is charged for the value of the patent rights and that the return to the intangible is embedded in the sales price of the Gizmos.
23 See generally reg. section 1.864-4(b), Example 3 (by implication).
24 See section 863(b) (last sentence); reg. section 1.863-3(c)(1). Section 865(e)(2) would not apply in this scenario because Forco is not using a U.S. office or other fixed place of business to sell goods in the United States.
25 See reg. section 1.861-7(a), (c).
26 Thus, section 865(e)(2) would not apply.
27 See reg. section 1.865-3(d)(2); sections 863(b) (last sentence), 864(c)(4)(A), and 865(e)(2).
28 See Lori Fisler Damrosch and Sean D. Murphy, International Law: Cases and Materials 385 (2019) (regarding U.N. members); Peroni, Brown, and Fleming, supra note 1, at 66-68 (regarding U.S. treaty partners).
29 See generally Fleming, “Searching for the Uncertain Rationale Underlying the U.S. Treasury’s Anti-Treaty Shopping Policy,” 40 Intertax 245 (2012).
30 See Peroni, Brown, and Fleming, supra note 1, at 73-74.
31 U.S. model income tax convention, art. 22 (2016); see H. David Rosenbloom, “Hungary, Farewell,” Tax Notes Int’l, Feb. 12, 2024, p. 889 (describing how the absence of an LOB provision in the recently revoked Hungary-U.S. income tax treaty allowed Hungary to become a tax haven). The 2016 U.S. model treaty was published in hopes of influencing the 2016 OECD Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, opened for signature in June 2017, including article 7 (prevention of treaty abuse). Article 7 provides options for alternative treaty limitations on benefits provisions. None of the alternatives follow the U.S. model treaty provisions, although a simplified LOB provision in combination with an anti-conduit rule comes the closest. A U.S. model-style LOB provision would be acceptable as an alternative to those specified in article 7 of the MLI. The United States has not signed the MLI, and the only U.S. treaty negotiated since the 2016 U.S. model treaty and the MLI — with Croatia (an MLI signatory) — follows the 2016 U.S. model treaty’s LOB.
32 U.S. model income tax convention, art. 22.1 (2016).
33 U.S. model income tax convention, art. 22.2.(f)(i) (2016).
34 U.S. model income tax convention, art. 22.2.(d)(i) (2016).
35 U.S. model income tax convention, art. 22.3.(a) (2016); see Christopher Callahan and Scott M. Snyder, “More Than a Decade in the Making, the Chile-U.S. Tax Treaty Takes Flight,” Tax Notes Int’l, Feb. 19, 2024, p. 971, 975 (indicating that the LOB provision in the recently ratified Chile-U.S. income tax treaty contains an active business exception).
36 In this scenario, the foreign subsidiary lacks a U.S. trade or business. See supra text accompanying notes 22-24.
37 Joint Economic Committee, “Report of the Joint Economic Committee, Congress of the United States, on the 2022 Economic Report of the President,” at 9, 117th Cong., 2d sess. (June 23, 2022).
38 Staff of the Joint Committee on Taxation, “Tax Incentives for Domestic Manufacturing,” JCX-15-21, at 66 (2021).
39 Katelynn Harris, “Forty Years of Falling Manufacturing Employment,” in U.S. Bureau of Labor Statistics, at 2, Beyond the Numbers: Employment and Unemployment (Nov. 20, 2020).
40 See Joint Economic Committee, “Report of the Joint Economic Committee, Congress of the United States, on the 2023 Economic Report of the President,” at 8, 118th Cong., 1st Sess. (July 27, 2023). These measures are the CHIPS Act of 2022 and the Inflation Reduction Act of 2022, which were intended, in part, to stimulate domestic employment. Thus, these enactments, coupled with the GILTI tax expenditure, create the curious and counterproductive situation of the U.S. government acting to simultaneously encourage and discourage U.S. manufacturing employment.
41 Compare Harris, supra note 39, with U.S. Bureau of Labor Statistics, “Industries at a Glance: Manufacturing: NAICS 31-33” (June 12, 2024) (19.55 million U.S. manufacturing employees in June 1979; 12.96 million U.S. manufacturing employees in May 2024).
42 See U.S. Bureau of Labor Statistics, “The Employment Situation — July 2024,” News Release USDL-24-1571, table B-1 (Aug. 2024) (relatively flat U.S. manufacturing employment growth in 2024); Bob Tita, “America’s Post-Covid Factory Boom Cools Off,” The Wall Street Journal, July 29, 2024, at B1 (detailing lack of growth in U.S. manufacturing); Harriet Torry and Anthony DeBarros, “Recession Less Likely, but Slowdown Is Seen,” The Wall Street Journal, Jan. 16, 2024, at A2 (Wall Street Journal survey of economists predicts slow manufacturing employment growth in 2024).
43 JCT, supra note 38, at 67.
44 U.S. Bureau of Labor Statistics, “Employment Situation,” Economic News Release, table B-8 (June 7, 2024) (showing that average weekly manufacturing earnings exceeded average weekly service-providing earnings in a May 2023 to May 2024 comparison, and the excess was 14 percent in May 2024).
45 Release by Joint Economic Committee Chair Don Beyer, D.-Va. (Feb. 8, 2022); see also Repetti, supra note 7, at 1334-1348 (discussing the harmful effects of the decline in U.S.-based manufacturing, including the disparate impacts on less-educated and minority workers).
46 See Congressional Budget Office, “An Update to the Budget and Economic Outlook: 2024 to 2034,” at 1 (2024) (publicly held U.S. government debt is projected to reach 122 percent of GDP at the end of 2034).
47 But see Repetti, supra note 7 (arguing that the contract manufacturing regulations (reg. section 1.954-3(a)(4)(iv)) and the check-the-box regulations (reg. sections 301.7701-2 and -3) have had a causal effect on the reduction in U.S. manufacturing employment).
48 Before 2018, the primary driver of the U.S. international tax system’s preference for foreign manufacturing was deferral of U.S. residual tax on income earned in low-tax foreign countries by foreign subsidiaries of U.S. corporations. See, e.g., Peroni, Brown, and Fleming, supra note 1; Fleming, Peroni, and Stephen E. Shay, “Worse Than Exemption,” 59 Emory L. J. 79 (2009). The GILTI regime could not have played a significant role in the 1979-2019 manufacturing job decline because it did not become effective until 2018. That regime, however, likely has played a part in the slow post-2017 manufacturing employment recovery identified supra in notes 38 and 39. See also Marc Levinson, “Job Creation in the Manufacturing Revival,” Congressional Research Service R41898, at 2-3 (July 19, 2019); Repetti, supra note 7, at 1331-1333; Sullivan, “U.S. Multinationals Moving Jobs to Low-Tax, Low-Wage Countries,” Tax Notes, Apr. 14, 2008, p. 119 (all discussing nontax causes of manufacturing job losses).
49 See CBO, supra note 46 (projecting growth in the annual federal deficit from 6.5 percent of GDP in fiscal 2025 to 6.9 percent of GDP in fiscal 2034).
50 See JCT, “Estimates of Federal Tax Expenditures for Fiscal Years 2023-27,” JCX-59-23, at 29 (2023) (scoring the GILTI regime as a $218.26 billion tax expenditure for the 2023-2027 period); Fleming, Peroni, and Shay, “Viewing the GILTI Tax Rates Through a Tax Expenditure Lens,” Tax Notes Federal, Dec. 12, 2022, p. 1525 (arguing that the GILTI tax rates are indisputably a tax expenditure).
51 Before the TCJA, deferral of U.S. income tax liability was the primary U.S. tax subsidy for foreign business operations of U.S. multinationals. Subsidy defenders said it was justified because it made U.S. corporations competitive in foreign markets, in turn benefiting the U.S. economy, including increased U.S. employment, which legitimated the subsidy’s cost. See National Foreign Trade Council, supra note 9, at 12, 56, 113-116. We have detailed the weaknesses in this argument: See, e.g., Fleming, Peroni, and Shay, supra note 48; Fleming and Peroni, “Reinvigorating Tax Expenditure Analysis and Its International Dimension,” 27 Va. Tax Rev. 437, 534-541 (2008). Moreover, the long-term decline of U.S. manufacturing employment belies any argument that the deferral subsidy increased employment in the manufacturing sector. These points apply fully to the post-2017 GILTI tax preference for foreign manufacturing income.
52 See Levinson, supra note 48, at 18-19 (discussing the challenge of creating additional manufacturing jobs); Reuven S. Avi-Yonah, “The Case for Targeted Location Incentives,” Tax Notes Federal, May 13, 2024, p. 1225 (discussing the use of tax incentives to attract employment to particular locations).
53 This should take account of any applicable global anti-base-erosion top-up tax to a 15 percent ETR as measured under the pillar 2 regime.
54 We take no position here on whether the corporate tax rate in section 11 should be increased above 21 percent (and, if so, how high) or whether a graduated corporate rate structure should be reinstated, despite the three of us having views on these important tax policy issues. Our position is that whatever corporate tax rates Congress enacts should apply in full to a U.S. corporation’s GILTI inclusions (including its foreign manufacturing income). Stated differently, our position is that whatever corporate tax rates Congress enacts should apply in full to a U.S. corporation’s worldwide income, including its income earned through controlled foreign subsidiaries (without deferral).
55 As noted, this article does not analyze the tax policy appropriateness or the efficacy of the section 250 deduction for FDII, which is an important separate topic.
END FOOTNOTES