RPC Must Read November 8, 2011

“What is tax reform?”: Moving Toward a Territorial System & the Tax Treatment of Foreign Source Income

The U.S. system of taxing the overseas income of U.S.-based multinational companies makes it difficult for these companies to compete in an increasingly competitive global market.  Broad spectrums of business leaders and stakeholders have voiced support to move away from our current residence system of taxation and move toward a territorial system of taxation.  The United States is one of only a handful of countries that currently employs a residence (often called “worldwide”) international tax system.  This system taxes its own residents (or domestic “resident” corporations) on all worldwide income, regardless of geographic source.  Thus, a company is taxed on any income that is earned within its borders as well as income earned throughout the world.  This complex system has induced tax inefficiencies and arcane tax rules to avoid double taxation of foreign source income such as the foreign tax credit and deferral.   Efforts to address our foreign tax system and our treatment of deferred income abroad adhere to the core goals of creating a tax code that is efficient, simple, and fair.

1. Moving Toward a Territorial System: 

a.      Our current worldwide system promotes income shifting by multinational companies.  This has caused the tax-neutrality of the U.S. tax code to erode.  Furthermore, many of America’s major competitors abroad operate under a territorial system.  A territorial system only taxes income earned within a country’s borders, regardless of citizenship or residence of the taxpayer entity.  Thus, active business income derived from a foreign source is exempt from taxation.  There is a wide range of perceived benefits to adopting a form of a territorial tax system. 

b.      Moving toward territorial taxation would boost American competitiveness.  The necessity to create tax code provisions in an attempt to avoid double taxation will no longer be needed.  Corporate compliance and government enforcement costs for the public would dramatically decrease.

2. Treatment of Foreign Source Income: 

a.      A U.S. firm with overseas operations can indefinitely postpone its U.S. tax liability on foreign income by operating through a foreign subsidiary. U.S. tax liability is deferred (postponed) as long as its foreign earnings remain in control of its foreign subsidiary and are reinvested abroad.  This policy is known as “deferral”. Tax is paid on overseas earnings only when they are brought back (repatriated) to the U.S. parent corporation as dividends or other income.  This process is known as “repatriation”.  This system creates a “lockout effect” that traps business capital abroad.

b.      It is estimated that U.S. companies are holding $1.4 trillion in foreign income abroad.  Our current worldwide tax system has created heavy reliance on the U.S. deferral provision in efforts to remain globally competitive.  Transitioning toward a territorial system could allow these profits to return to the U.S. under a deemed repatriation tax rate substantially lower than our current 35% rate.  There has been a longstanding debate regarding a “clean” policy that allows multinationals to repatriate their income and use it to their discretion, or a policy that forces companies who return their income to invest toward specific business provisions (e.g. workforce expansion, infrastructure, etc.). Certain proposals in Congress have sought to hinder the flexibility of foreign source income returning to the United States. 

Our current tax structure and treatment of foreign source income is outdated and uncompetitive in the global marketplace.  It has grown increasingly complex in the years since the United States last comprehensively reformed its tax code.  The consistent increase of tax preferences embedded in the code to combat the lack of global competitiveness is counterproductive to pro-growth tax reform. 

Policymakers have made progress in recognizing the importance of reforming our international tax structure.  Territorial reform would promote tax neutrality that will allow multinational companies to make business decisions based on growth rather than tax treatment. Foreign source income would be able to return to the United States for investment under a more favorable, and thus more competitive, system of taxation.  This will broaden the tax base and allow the opportunity to lower marginal tax rates.  A territorial structure can establish these pro-growth policies and transition the United States to a more efficient, simple, and equitable tax code.