Understanding the Meaning of BEPS for the United States

By / 10.2.2015

Multinationals are about to get hit with a big tax penalty for operating in the United States. Is it finally time for corporate tax reform?

On Monday October 5 the OECD will release the “final package of measures for a co-ordinated international approach to reform the international tax system.”  These BEPS recommendations (standing for Base Erosion and Profit Shifting) are intended to address “gaps and mismatches in existing rules which allow corporate profits to ‘’disappear’’ or shift to low/no-tax locations, where no real value creation takes place.”  In other words, the goal is to make sure that multinationals pay their fair share of taxes globally. This is a laudable objective.

But BEPS also exposes the huge difference between the U.S. corporate tax rate, and that of many of our rivals. According to KPMG, the posted U.S.  corporate tax rate, including both federal and state, stands at about 40%.  By comparison, the average corporate tax rate in the European Union is about 22%. That includes Ireland (12.5%),  United Kingdom (20%) and Germany (roughly 30%). To put this in perspective, a company earning an extra $1 billion in profits in the United States would pay roughly $400 million in corporate taxes, versus only $200 million in taxes if the profits were booked in the United Kingdom. That difference of $200 million could fund thousands of jobs.

Before BEPS, many U.S.-based multinationals were able to legally reduce their U.S. tax bills by  shifting income to other countries with lower rates. They used a variety of tax strategies. The result for the companies: Lower effective taxes. The result for the United States: Higher competitiveness, since multinationals could avoid the full brunt of the excessively high U.S. corporate income tax rate.

Post BEPS, many of these tax avoidance strategies will no longer be possible. The basic principle behind BEPS is that companies should pay corporate taxes in the countries where value is created. In practice, that will often mean they pay taxes where their workers are located.

Many multinationals are likely to pay more taxes somewhere. But the bad news is that it will become crystal clear in financial statements that companies doing R&D in Silicon Valley, says, or producing advanced machinery in the Midwest, will effectively suffer a corporate tax penalty of 10-20% compared to operating in low-tax countries such as the UK.  Investors will increasingly put pressure on multinationals to move more of their operations and jobs out of the US to places with lower tax rates.

Almost certainly, BEPS will make the United States less competitive globally, because the high US corporate tax rate will bite harder. The United States will lose jobs,  including the sort of high-paying creative jobs that create economic value. (See my previous report “The BEPS Effect: New International Tax Rules Could Kill US Jobs”).

The best solution is for Congress to reform the corporate tax system by lowering rates and closing loopholes, preferably as soon as possible. While these BEPS reports are officially just recommendations, in practice many parts of them are already being adopted by individual countries. Moreover, the philosophy of BEPS–tax companies where they create value–is already seeping into the reasoning of tax authorities around the world.

BEPS is going to blow away the fog that has previously obscured the global corporate tax system. American legislators are going to find out much to their surprise, that there are consequences for imposing a big tax penalty on companies that operate in the US.