The following is a piece written by Bill Parks, CEO of NRS, Inc., in Moscow, ID, and CPA member and supporter.

The corporate tax system be modified to fairly collect revenue from multinational corporations like Google and to close the loopholes that now make it possible to game the system. Alan J. Auerbach recommends “a system that ignores all transactions except those occurring exclusively in the United States” [ii] to replace the current system of taxing earnings from foreign sources. [iii]

Foreign source taxation made sense in the 1950s and 1960s when so many corporations based both their headquarters and manufacturing operations in the United States. Today, however, many corporations not only manufacture around the world but also frequently transfer a part of their operations to low tax jurisdictions that ostensibly create most of the corporation’s profit. Antiquated tax laws allow many corporations to escape paying their share while leaving companies that play fair at a competitive disadvantage.

Along with limiting taxes to U.S. transactions, Auerbach advocates switching to a cash flow model.[iv] However, switching to a cash flow model would drastically alter accounting systems, causing potentially damaging disruption. Professor Reuven Avi-Yonah argues that calculating taxes on the cash flow model would not stop the practice of shifting foreign-source funds, but could even increase it through manipulating transfer pricing.[v]

Fortunately, it is not necessary to use a cash flow model to achieve Professor Auerbach’s primary goal of taxing corporate profits associated with all domestic sales. Instead, we can counter the problem of unequal tax burdens by assessing taxes on the same percentage of worldwide profits that U.S. companies contribute to worldwide sales. Calculating this percentage would require firms to report revenues and expenses to the IRS using International Financial Reporting Standards (IFRS).[vi] These standards are becoming accepted and required around the world. The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) are working towards convergence of IFRS and Generally Accepted Accounting Principles (GAAP).

A simple formula illustrates the concept:

TL = USR/WWR x (PIFRS)

Where:

TL=Tax Liability

USR=United States Revenue

WWR=World Wide Revenue

IFRS=Profits using the International Financial Reporting Standards (IFRS)[vii]

In this model, taxes paid to foreign jurisdictions[viii] would be deductible as an expense and no longer allowed as a credit against U.S. income tax. Foreign companies selling in the U.S. would follow the same calculations and rules to pay taxes based on the percentage of their overall sales made in the United States. Any company, whether privately or publicly held, domestic or foreign, would be required to calculate worldwide sales and pre-tax profits using International Financial Reporting Standards.

Some have suggested formulas that would add payrolls and assets to sales in calculating liability for U.S. corporate taxes. Taxing formulas that include payrolls and assets would likely prove counterproductive because they would discourage companies from locating employees or assets in the U.S. Payrolls and assets create other tax revenues and are beneficial to the domestic economy. Not counting them would encourage domestic employment and investment.

To counter attempts at system gaming, it is important that any company selling in the U.S. present consolidated statements as part of its tax report. This consolidation must combine all subsidiaries and affiliated companies. Without this requirement, there will continue to be techniques that hide profits in those other companies.

One additional change would be that taxes paid in any jurisdiction would be a deductible expense, but not a credit. Further investigation would be required to settle on the correct incidence of some financial and royalty transactions.

Along with limiting corporate taxation to U.S. transactions, Auerbach suggests that interest, because of its role in creating debt-related economic instability, and for many other reasons, should no longer be a deductible expense. While he achieves this with his cash flow proposal, I suggest a more straightforward method of simply phasing in the removal of interest deductibility over a period of time. Additional measures, such as providing tax incentives for forming C corporations, will further encourage better growth and less volatility for small business. There’s no doubt that an adequately internally financed small business component would create a much stronger overall economy than exists today.

Nixing the “Nasty Notch”

In 1986, the desire of liberals to avoid rewarding high-net-worth small business owners meshed with the conservatives’ desire to allow small business owners to avoid corporate taxes altogether. The result was a greatly expanded opportunity for small businesses to become S corporations. The consequence was that the small businesses which remained C corporations were subject to a surtax. This 39% marginal tax rate on income between $100,000 and $335,000, “the Nasty Notch”, [ix]has the unintended consequences of not only discouraging C corporation formation, but also causing existing, small C corporations to switch to S corporations or LLCs. In so doing, small businesses have successfully avoided the corporate tax, but at the same time, they have avoided retaining the earnings critical to grow successful businesses.[x]

Over the last three years, small businesses learned that bank loans are no longer automatic. Combine the tight credit with reduced revenues and profitability and many businesses suffer. Graduating corporate taxes up to at least one million dollars would provide a powerful incentive for small businesses to become C corporations and concentrate on retaining earnings and growing through reinvestment rather than through borrowing. Less borrowing means more stability.

Blame the banks if you must, but years of taking out most or all of small business earnings has created an insatiable demand for credit by businesses that are not credit worthy in all but the best of times. Indeed, tax experts and economists seem unaware that the Tax Reform Act of 1986 caused many small businesses to avoid reinvesting the earnings necessary for growth. They think that venture capital and other outside funding sources fill small business’ investment needs. [xi] They do, in fact, for some industries such as high tech, but many owners wouldn’t want outside investors, even in the unlikely event they were available. Self-financing is the norm for small business, and second mortgages, home equity loans and even credit cards are the methods. Why does this matter? Recent small business distress shows the consequences of underfinanced small business.

In concert with the changes in the corporate tax schedule listed above, congress could consider giving an immediate economic boost to these small businesses by allowing small businesses to elect to be taxed as C corporations at any time. [xii] This liberalized election would give immediate tax relief and extra cash to small businesses at a time when small business needs this incentive.

With a properly graduated corporate tax schedule, hundreds of thousands, or even millions, of S corporations and LLCs would choose to grow by being taxed as corporations as soon as they were profitable.

Updating tax recommendations from the 1980 White House Conference on Small Business to account for inflation and the change in individual rates would create the following corporate tax schedule: 15% up to $100,000; 20% from $100,000 to $500,000; 25% from $500,000 to $1,000,000; and 30% above $1,000,000. [xiii] The 1980 recommendations are even more valid today, and this would be an excellent time to adopt them permanently.

Too Big to Fail: An Alternative Strategy

Some in Washington want to downsize companies deemed too big to fail. Given that there is little agreement on how to do that and who should make those decisions, it is unlikely that anything will be done on this front to reign in the largest companies. Still, reign them in we must.

Anti-trust enforcement has not been a government priority for more than thirty years, but the events of 2008 revealed the danger of letting companies grow unabated. The idea that one stop shopping applies to financial instruments as much as it does to bread and milk rests on very little evidence of real scale economies. Instead, the benefits seem to rest on market power (meaning the ability to raise prices), self-dealing and aggrandizement. Do these benefits to business outweigh the danger that “too big to fail” companies present to the economy?

Imposing tax disincentives for creating giant companies would help reign in growth of the largest companies while raising new revenues and creating little or no new bureaucracy. By moderately graduating corporate taxes at the upper end, companies with real scale economies would still be likely to merge and acquire, but many others would find that disaggregating the company would make more economic sense. Further study would be necessary to create the most efficient and effective tax schedule, but keeping the 35% rate for before tax profits above one billion dollars and 40% above ten billion would seem a reasonable starting point for discussion.