A Primer on Tax Deferral
Most multinational companies registered in America have business interests outside of the United States. Since the United States has a worldwide tax system, the business income generated abroad is also subject to taxation in the US as well. However, they do not have to pay these taxes immediately. American corporations can use certain tax-deferral rules in order to indefinitely delay the payment of taxes on their foreign operations.
Tax deferral has been strategically used by many corporations in order to spur growth. In this article, we will have a closer look at what tax deferral is and how it can provide economic benefits to certain American companies.
What is Tax Deferral?
Tax deferral is a tax policy in the United States. American companies that take advantage of this policy often create offshore subsidiaries. Once they generate income from these offshore subsidiaries, they do not transfer it to the American parent. Instead, they keep it in the subsidiary for an indefinite amount of time. The American tax system does not charge tax on foreign income when it is earned. Instead, it charges tax on foreign income when such income is repatriated to the United States. Even when the income is repatriated back to the United States, tax credits are given for the tax, which was paid in the original country.
Many critics are of the opinion that this policy is advantageous to the companies while hurting the overall American economy. This is because tax deferral rules make foreign investments more attractive than local investments. Even if the project generates the same cash flow in both countries, companies will prefer to invest abroad since they can defer tax cash flows indefinitely.
Why is Tax Deferral Advantageous to Companies?
Tax deferral is advantageous to companies because it allows them to gain in terms of the time value of money. When companies do not have to pay taxes immediately, they can put the money to work by reinvesting it in the business. If the money earns a decent return (lets say 14% per annum), it would have tripled in value over the next decade. However, when the company repatriates the money back to the United States, they only have to pay taxes on the original amount. Also, since companies can use tax money to invest in the business, they have to take on less debt. This less debt shows up as less leverage and increases investor confidence in the business. Hence, tax deferral can be thought of as an interest-free loan from the government to the company.
Companies in the United States have used this strategy to the hilt. It is estimated that 83% of American corporations have opened up subsidiaries in tax havens across the world. As a result, they simply keep their income bottled in the tax havens in order to avoid taxation by the US government. This money is sent to the United States at an opportune time i.e., when the company is facing losses. Tax experts have estimated that over $60 billion is stashed by American companies in tax havens every year!
Why is Tax Deferral Allowed?
From the above points, it seems like tax deferral is only advantageous to the companies which use it and not to the tax authorities. However, it has been allowed for several years by the tax authorities because of the following reasons:
Which Types of Incomes Can Use Tax Deferral?
The American tax law prescribes specific types of incomes that can use deferred tax rules.
Hence, it can be said that the ability to defer tax on foreign incomes is an important tax benefit that has been built into the American tax system. Using these loopholes, companies were avoiding the payment of tax for long periods of time. Donald Trump has decided to lower these tax rates so as to encourage companies to repatriate their funds more often.
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