In Corporate Taxes, It’s The Tax Base That Matters

By Jeff Ferry, CPA Research Director

Last year, pharmaceutical giant Pfizer lost $8.5 billion in the US market. How can that be, you may be wondering? 

How could one of our most successful companies, selling high-priced, popular drugs like Lipitor, Premarin, Lyrica and Viagra, lose money in the world’s most lucrative drugs market, the good ol’ USA? Well, Pfizer claims to have earned $16.9 billion in foreign markets. Worldwide, it earned $8.4 billion in pretax profit. Pfizer’s US losses are created by clever accountants to avoid US taxes, making income appear to have been earned in tax haven countries.

In their just-announced tax reform plan, the Republicans are focusing on the corporate tax rate. But that’s the wrong variable to look at. The tax base is much more important than the rate, because the tax base determines the corporate profit that can be taxed. A broader tax base enables a lower tax rate. And if Congress does not change the tax base, then cutting the rate will prove a short-lived benefit, because continued erosion of the base will mean tax revenue will decline further and rates will need to go up again in the future. 

The core problem in today’s corporate tax system is that we say we have a worldwide tax system but in reality we tax mostly corporate income (profit) booked in the US. Since the 1980s, our corporate tax system has accumulated a vast number of loopholes, deductions, exclusions, and special treatments, especially for taxes paid to overseas governments and for income earned in overseas subsidiaries. Our corporate system today is like a colander, with what should be taxable corporate income pouring out into all sorts of tax havens where it escapes the reach of the IRS.

 Skillful management of its profits enabled Pfizer to hold down its US corporate tax payment to $342 million, for an actual US federal tax rate of 4.1%. (It did pay over $1 billion in foreign corporate taxes.)  Other major corporations follow the same playbook, minimizing the taxes they pay to the IRS.

The best-known of the corporate tax giveaways is the deferral of foreign income That has allowed an estimated $2.6 trillion of US corporate profit to be kept overseas and escape corporate taxation. But there are dozens of other loopholes. Some have exotic names like the “Dutch sandwich” used by some large corporations to reduce taxes by moving profit in and out of the Netherlands a couple of times. Others involve tax havens like Bermuda or the Cayman Islands. Some involve special deals negotiated with governments that have targeted the attraction of US tax vehicles into their countries. Ireland and Luxemburg have played that game extremely well over the past two decades. 

Sales Factor Apportionment

With the huge, and growing, opportunity to shift profit outside the borders of the US, no cut in the corporate tax rate can last. The solution is a new tax system that prevents tax haven abuse and requires companies to pay taxes on profits from sales in the US. The Trump administration should move to a new tax system called formulary apportionment or sales factor apportionment (SFA).  Under this system, it doesn’t matter where a company like Pfizer “books” its profits. In an SFA system, a company pays tax on that portion of its worldwide pretax profit that corresponds to the portion of its sales that were generated in the US market. Thus, the tax base depends only on two figures, worldwide pretax profit, and US sales (as a share of total sales). For public companies, these figures are typically disclosed in quarterly reports to shareholders and/or SEC filings. Crucially, larger companies have no incentive to minimize these figures and in fact incentives to show investors strong worldwide profit as well as strong sales in the highly coveted US market.

An analysis we carried out recently on 87 of the largest US corporations, to be published in industry journal Tax Notes in late November, examined the financial reports of these companies and concluded that under an SFA system, the US Treasury would have reaped an additional $116 billion in corporate tax revenue. That’s an increase of 34% over actual US corporate tax revenue in the most recent year. That additional revenue could be used to pay for much-needed federal programs, or it could enable a cut in the corporate tax rate by nine points, from today’s 35% to 26%. This is a large cut in the corporate tax rate, meeting Republican political objectives and potentially spurring an increase in investment in US plant and equipment by US corporations. 

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