How to tax US companies" foreign profits On Wednesday the Obama administration proposed a long-awaited cut in the top rate of US corporate tax from 35 per cent to 28 per cent. But the White House also disclosed something more contentious. The administration is suggesting US companies" foreign earnings should be subject to a "minimum tax." The current system for taxing earnings of foreign subsidiaries controlled by US companies is controversial and counterproductive. Such foreign earnings are theoretically taxed at a 35 per cent rate if brought back to the US, but not taxed at all by the US as long as these earnings are kept abroad. Faced with this choice, US companies are unsurprisingly holding abroad more than $1.5tn in foreign profits. The current tax system thus discourages US companies from using their foreign profits to build facilities in the US or buy American companies. It also generates almost no tax revenues for the US Treasury. To replace the current system, business lobbyists have suggested the US follow the lead of other industrialised countries by adopting a "territorial" system for taxing foreign profits of domestic corporations. In such a territorial system, the foreign profits of US companies would be taxed only in the country where they were earned, and not by the US. However, none of our major trading partners actually has a pure territorial system for taxing foreign corporate profits. Almost all countries impose domestic taxes on "mobile" corporate income such as investment interest. And many still collect taxes on corporate income earned in tax havens. These tax havens violate the fundamental premise supporting a territorial system - that foreign profits are already effectively taxed where they are earned, so should not be taxed again in the home country. Mr Obama's idea could fix this problem by ensuring that all foreign profits of US companies are taxed once at a minimum rate - either by the US or another country. To be workable, this proposal should have three main components. First, Congress should enact a permanent tax exemption for US corporate profits earned in countries with effective corporate tax rates above a specified minimum. The minimum rate should be no higher than 20 per cent because that is the effective corporate tax rate in most of our major trading partners, according to a 2011 study by the National Bureau of Economic Research. Second, Congress should levy a minimum tax on US corporate profits in any tax haven to prevent a "race to the bottom" in which countries bid for corporate facilities by offering to minimise corporate taxes. In other words, the US would no longer allow its corporations to defer indefinitely US taxes on any profits allocated to these tax havens. This general rule should be subject to a major caveat for low-tax jurisdictions where corporations conduct actual operations. A US company should receive a credit against the minimum tax for the taxes it actually paid in such a jurisdiction. For example, if the profits of an Irish subsidiary of a US corporation were taxed at 12.5 per cent in Ireland and the US minimum tax was 20 per cent, these profits would be subject to a US tax of only 7.5 per cent. Third, Congress should allow all corporate profits earned overseas before 2012 to be repatriated to the US at a low rate, such as 8 per cent, for the next two or three years. This low rate would facilitate the transition to a better permanent system, and would not be part of a one-off tax holiday for repatriated corporate profits. Another tax holiday would merely reinforce the current counterproductive system for deferring US taxes on foreign profits. Such a transitional rule is needed because corporations reasonably relied on the current system in the past - which allowed US corporations to defer US taxes forever on all their foreign profits as long as they were kept abroad. It would be unfair to impose a minimum tax now on a corporate strategy that was perfectly legitimate for many years. This three-part proposal would be superior to the current system, which discourages US companies from deploying their foreign profits in the US and raises almost no tax revenues for the US. This proposal would raise revenues from US corporate activities in jurisdictions with no or low taxes, while encouraging US corporations to use their foreign profits to build facilities and create jobs in the US. The critical political question that Mr Obama needs to answer is: what should be the minimum tax rate? Although 20 per cent is the effective corporate tax rate in our major trading partners, business lobbyists might push for a lower rate - such as a 12.5 per cent rate, like in Ireland. Critics might say even 20 per cent is too low, relative to the newly proposed 28 per cent rate on domestic corporate profits. However, with the effective US tax rate on foreign profits of US corporations currently at zero, there should be clear incentives for even Congress to reach a reasonable compromise The writer is chairman emeritus of MFS Investment Management and a lecturer at Harvard Business School