Minnesota’s Proposed Taxation of Foreign Earnings: What We Know

Confession: I have given up trying to understand the complexities of how taxing foreign profits now works.   Territorial vs. worldwide vs. destination-based corporate tax systems and hybrids thereof; participation exemptions; all the definitions and rules surrounding controlled foreign corporations, unitary groups, transfer pricing, and foreign tax credits; Qualified Business Asset Investment; Subpart F income; the acronym stew of new categories of income and taxes and how they work (e.g. GILTI, FDII, and BEAT, a.k.a. Global Intangible Low Taxed Income, Foreign Derived Intangible Income, and Base Erosion and Anti-Abuse Tax respectively) - the list goes on and on.   The goal of the TCJA with respect to corporate taxation was to address and balance two important policy matters simultaneously: create a system that is globally competitive while at the same time tackle the very real and legitimate problem of corporate profit-shifting and tax base erosion.   MCFE members steeped in this world have patiently answered my questions but every response seemed to send me scrambling to another section of the Internal Revenue Code for another definition or to try to gain familiarity with another issue.

As a result, I admit to some bemusement juxtaposing my experience grappling with this topic with how a provision in the House omnibus tax bill (HF 991) to tax foreign earnings was talked about in recent legislative hearings.  The testimony made it all sound so easy.  Pass a law and, voilà, hundreds of millions of dollars in recurring revenue from big tax scheming corporations are available to fund education, health care, and a lot of other essential state services.  It reminded me a little bit of that old South Park cartoon scene-turned-viral-meme in which tiny humanoids called the Underpants Gnomes present a business plan:

• Phase 1: Get underpants
• Phase 2: ?
• Phase 3: Profit!

This provision is pretty much guaranteed to not make it out of conference committee (and for that matter is not even in the Governor’s tax proposal).  But interest in having the state get its share of foreign income on top of the federal government’s efforts is not going away. 

In spite of our white flag now waving in the breeze, there are a few things we now do know about state efforts to go after foreign profits:

We know what we are looking to capture is fundamentally flawed and in need of reform.

GILTI - a focus of the House bill — was created by Congress at warp speed under purely political time constraints, and the resulting problems have now become evident.   Martin Sullivan, former U.S. Treasury staff economist, chief economist and contributing editor of Tax Analysts, and a long-time investigator and critic of multinational tax avoidance has this to say about GILTI as a solution:

In general, a minimum tax on foreign profits is an excellent disincentive to profits shifting. Unfortunately, the all-important details of the GILTI provisions, which are overlaid in existing complex rules, are mind-numbingly complex and arbitrary.  And the economics stink too.  In some cases, GILTI provides negative marginal tax rates on foreign investment. In other cases, it provides marginal tax rates well in excess of the US or foreign statutory rate. Major reforms and simplifications of GILTI must be undertaken by Congress passing new law. Treasury cannot fix the major problems by regulation.^[1]

This is on top of the more fundamental issue of whether Minnesota can tax income earned entirely outside this state, let alone this country, by an entity that itself has absolutely no connection (“nexus”) to Minnesota.  Moreover, according to recent statements by Treasury Secretary Janet Yellen, the U.S. will adopt a more cooperative approach to working with the Organization for Economic Cooperation and Development (OECD) in its ongoing initiative to develop and implement a global minimum tax. Depending on the progress of this initiative, the GILTI provisions would undergo substantial change if not repealed altogether.

We know corporate income taxation by subnational governments is quite rare in the world. 

Of the 48 other countries comprising the OECD -- representing nearly 90% of global GDP -- only eight have some form of subnational corporate income tax.  Only five include in their subnational tax bases passive income earned by foreign subsidiaries under the controlled foreign corporation (CFC) rules established under national law. Only one (South Korea) subjects active foreign source income to full subnational taxation (at a maximum rate of 2.5%).^[2]  It’s a major reason why worldwide combined reporting was considered and rejected by the OCED in their efforts to address profit shifting and base erosion.  Most countries look unfavorably at subnational tax actions as resulting in unequal, adverse treatment of their own domiciled companies.  

We know that insufficient attention has been given, and understanding generated, on the additional administrative burdens and costs the state, and taxpayers, would incur.

To our knowledge, no public testimony was given by the Department of Revenue on the additional staffing and resources needed to handle compliance activities, auditing activities, enforcement activities, taxpayer appeals, legal support, return processing, outreach efforts, internal education and training initiatives, and other administrative matters to support a foray into GILTI taxation and worldwide combined reporting.  No fiscal note was prepared by the Legislative Budget Office on these matters.  A couple of years ago, what would appear to be a comparatively more modest bill which included a provision for a new private letter ruling program (which a majority of states have), making some changes to auditing domestic sales and use tax returns, and allowing refunds for up to two years after a tax was paid carried a $69 million biennial price tag and the addition of 130 full time equivalent employees for the Department. 

A typical large multinational with sales and operations around the world ordinarily has one-hundred or more controlled foreign entities around the globe — the income and loss of which would need to be reported on the Minnesota state return.  In the case of worldwide combined reporting, the current Minnesota tax form requires line by line aggregation of data and information for each foreign as well as domestic entity, as opposed to consolidated reporting used for financial reporting purposes.  That alone would seem to raise some question about staffing necessary to verify this information if it comes up in an audit.   We have no idea if a foray into international commerce is a big deal, little deal, or something in between, but we should have an understanding of what’s needed to do this, and do this accurately and responsibly, without creating unintended consequences for state tax administration.

We know nobody really has a good idea how much revenue this would bring in.

This is not disparaging the work of the DOR’s revenue analysis group or estimates generated by various organizations.  It’s just that asymmetrical information about firm activities and decision-making in dozens or hundreds of subsidiaries across the globe makes generating reliable forecasts on this matter extremely difficult. To illustrate, the Congressional Budget Office estimated that post-TCJA $235 billion in profits will continue to be shifted offshore annually.  That number simply represents a midpoint between two very different academic projections: one of $300 billion; the other less than half that total.  Research has shown firms do not provide sufficient information for even close observers and sophisticated users like financial analysts to interpret and predict the future tax implications of foreign operating activities, and that forecasting difficulty is greater for multinational firms regardless of whether foreign operations are inside or outside of tax haven countries.[3]  And no dataset exists that allocates corporate profits by state.    

We know building hundreds of millions of dollars of permanent government spending on this highly uncertain and volatile foundation doesn’t exactly ring the bell of fiscal responsibility.

Even staunch advocates like the progressive Center on Budget and Policy Priorities of Washington, DC has expressed caution on this topic noting, “States conforming to TCJA international provisions can reasonably anticipate legal challenges taking years to resolve.  Accordingly, states should not build revenue from conformity into budgets.”[4]  If Minnesota ultimately chooses to tax foreign earnings it would be wise to use it for one-time spending.  The state has a laundry list of such possibilities supporting the benefit principle of taxing businesses – highway projects, local sewer and water grants, and communications infrastructure to name a few. 

And, as we have suggested before, “closing the circle” by giving it to the State Board of Investment to reinvest and augment state pension support should be added to that list.  There is considerable irony in having state government decrying corporations for dodging their responsibilities while sitting on $16 billion in unfunded pension liabilities using practices that aren't found anywhere else in public or private finance.  This messaging would have a lot more moral authority if government wasn’t embracing its own legal but dubious accounting practices in order to avoid addressing its own economic obligations.