Recs

17

The Fiscal Cliff's Biggest Danger

As the end of 2012 approaches, the so-called "fiscal cliff" of tax increases scheduled to take effect for the 2013 tax year has gotten a lot of attention. Some policymakers have called for extensions of current tax cuts, while others seek more broad-based tax reform that could have even bigger impacts on both companies and individual taxpayers.

One aspect of the tax debate that many policymakers ignore, however, is the fact that when it comes to taxation, businesses constantly respond to changing conditions. In particular, if tax conditions in the U.S. get worse for the big corporations that represent a massive part of the overall corporate tax base, then you can't count on them just to pay up. Rather, they'll move on to greener pastures, leaving small businesses and ordinary taxpayers potentially footing an even bigger portion of the overall bill.

It's already happened
Many companies have already responded to the increasingly hostile tax environment by getting out while the getting's good. As a recent Wall Street Journal article highlighted, many companies have moved their corporate headquarters out of the U.S. in the past 10 years, taking advantage of other countries with more advantageous tax treatment to improve their bottom lines.

In particular, energy companies have been quick to move outside the U.S. for tax purposes. Weatherford (NYSE: WFT  ) and Transocean (NYSE: RIG  ) moved to Switzerland, where corporate taxes run at about 16% -- less than half the 35% U.S. corporate tax rate. Offshore drilling company Ensco moved to the U.K., and since the move, the company said its effective tax rate has fallen from 19% in 2009 to 10.5% during the second quarter of 2012.

But the trend has gone beyond oil and gas. Eaton (NYSE: ETN  ) is planning to merge with Cooper Industries and take advantage of an exception to a U.S. law that tried to clamp down on overseas moves. Because Cooper is an Irish company, Eaton can choose to have its new headquarters in Ireland as well, where corporate taxes run at around 12.5%. Similarly, insurance company Aon (NYSE: AON  ) established a new home in the U.K. and expects major tax savings as well.

What's wrong?
Moving to less tax-costly countries is just one tactic that corporations use to avoid the full impact of U.S. taxation. With other weapons in their arsenals, such as holding foreign profits offshore to keep from having to pay U.S. taxes on repatriated taxable income, U.S. corporations keep truly colossal amounts of income out of reach of the IRS.

Yet some proposed solutions don't really address the fundamental issue. Ideas like repatriation tax holidays and lower corporate tax rates could have a temporary impact and cause some short-term opportunistic responses among corporations. But as long as big gaps exist between different taxing jurisdictions, companies will have incentives to game the international tax system.

One interesting idea, though, would admit that trying to tax corporations is ineffective but would aim to collect by different means. Specifically, rather than imposing taxes on businesses, the IRS could borrow a page from provisions it makes for specialty niche companies and treat them as pass-through entities, taxing investors. Just as investors in Annaly Capital (NYSE: NLY  ) pay full ordinary income tax rates on their income, so could imposing higher tax rates on shareholder dividends (which could be made mandatory) also make tax collection more effective. And with corporate taxes eliminated, a higher tax on dividends could still leave investors ahead on an after-tax basis.

Only a partial solution
Of course, shunting tax liability onto shareholders raises its own problems, as collecting what might be considered U.S. source income from foreign taxpayers is often extremely challenging. But by taking the emphasis off companies with nearly endless resources to fight taxes and instead putting it on investors who generally lack those resources, the U.S. Treasury might end up ahead.

Solving the fiscal cliff won't happen overnight. But it's important for policymakers to understand the second-order effects that their tax proposals will have. Otherwise, they could end up doing exactly the opposite of what everyone intends for them to do.

Annaly gets a lot out of being a pass-through entity, but are shareholders setting themselves up for disappointment? Get the latest on the mortgage REIT giant in the Fool's premium report on Annaly. Our top analysts give you the lowdown, along with a year's worth of free updates, so don't wait -- get started today.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

Fool contributor Dan Caplinger treats danger very seriously. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital, Ensco, Transocean, and Aon. Motley Fool newsletter services have recommended buying shares of Annaly Capital and Aon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy stares danger in the eye.


Read/Post Comments (9) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 05, 2012, at 5:56 PM, DrDeVito wrote:

    This is kind of a cool idea but wouldn't this create an incentive for all companies to not pay dividends at all? Then they wouldn't need to pay taxes and instead just keep all the cash for themselves.

  • Report this Comment On September 05, 2012, at 7:25 PM, Gottamouthoff wrote:

    Holding a company that pays no dividend and hoping to sell later at a profit makes no sense to income and growth retirees.

  • Report this Comment On September 06, 2012, at 1:00 PM, mdk0611 wrote:

    Doc - A REIT is required to make a certain level of distributions to maintain exempt status. LLC's and "S Corporations" provide owners a K-1 with a pro rata amount of entity profit. If they didn't make cash distributions they'be be pretty unpopular investments.

  • Report this Comment On September 06, 2012, at 4:06 PM, Darwood11 wrote:

    While Rome burns, the politicians dance.

    One thing to be realized is this; the people in business are generally a lot smarter than our politicians are, and they have real incentive in figuring out these things. That incentive is simply keeping the money their companies have earned. Business people do this every day; it's called improving the bottom line.

    Politicians are busy figuring out ways to spend the money they collect as taxes. There is ample evidence they are very good at flushing it, but don't spend it very well.

    The politicians are always playing "catch up." For the most part, innovation occurs in the private sector. Most importantly, "financial innovation."

    That being the case, don't expect these people to come up with anything spectacular.

    Presently, the word is out and despite all of the rhetoric in Washington to the contrary, there are lots of places to anchor one's business overseas, and it isn't necessarily Bermuda. However, the politicians would have us believe otherwise, which is another way of saying they remain far behind on the curve.

    What we really need is a completely streamlined tax code, something suitable for the world of the 21st century. But with the current emphasis in Washington, and the overly simplistic talk about deficits, there is no way that will occur.

  • Report this Comment On September 07, 2012, at 4:47 PM, irvingfisher wrote:

    Companies in Canada started turning themselves in REITs-like entities (income trusts they were called) exactly for that reason. The government put a stop to it because tax revenues were dropping too much.

    The gvt also raised taxes on the dividend payments for the same reason. However they dare not raise the taxes any more because they had already really pissed off retirees who counted on the dividend income by raising the taxes in the 1st place.

  • Report this Comment On September 07, 2012, at 4:49 PM, irvingfisher wrote:

    It's a race to the bottom for corporate taxes. Canada has been cutting corporate taxes for years and all it got in return was lower tax revenues.

  • Report this Comment On September 12, 2012, at 12:15 PM, Whumpsnatz wrote:

    "Of course, shunting tax liability onto shareholders raises its own problems, as collecting what might be considered U.S. source income from foreign taxpayers is often extremely challenging.".

    Really? My foreign stocks haven't had any problems withholding 20 or 30% of my dividends.

  • Report this Comment On September 15, 2012, at 2:35 PM, thidmark wrote:

    We have one of the stupidest governments in the world. And absolutely zero leadership.

  • Report this Comment On December 10, 2012, at 5:43 PM, kyleaspop wrote:

    It seems to me that our government would do everything it could to keep big business in this country. There would be plenty of jobs, people would have money to spend, and the economy would be in good shape.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2006405, ~/Articles/ArticleHandler.aspx, 10/20/2014 4:56:24 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

Today's Market

updated 2 days ago Sponsored by:
DOW 16,380.41 263.17 1.63%
S&P 500 1,886.76 24.00 1.29%
NASD 4,258.44 41.05 0.97%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/17/2014 4:03 PM
AON $80.97 Up +1.04 +1.30%
Aon CAPS Rating: **
ETN $61.44 Up +1.52 +2.54%
Eaton Corp CAPS Rating: ****
NLY $11.20 Down +0.00 +0.00%
Annaly Capital Man… CAPS Rating: ****
RIG $28.78 Down -1.37 -4.54%
Transocean, Inc. CAPS Rating: ****
WFT $16.39 Up +0.08 +0.49%
Weatherford Intern… CAPS Rating: *****

Advertisement