Last week, in our reactions to President Obama’s proposal for corporate tax reform, we took special note of the president’s continued push towards a ”worldwide” international tax system; one that greatly expands the reach of the U.S. in taxing non-U.S. sourced income earned by foreign subsidiaries.
Most notably, we highlighted just how dramatically the president’s proposal deviates from those posited by the leading Republican candidates, who favor the “territorial” systems adopted by much of the developed world.
But what do “worldwide” and “territorial” international systems really mean? How do they compare to our current system? And more importantly, how would they change the way the U.S. currently taxes the icnome earned by foreign subsidiaries of domestic corporations?
To illustrate, let’s take a simple fact pattern:
X Co. is a U.S. corporation. X Co. owns 100% of Foreign Co., a foreign corporation that generates no revenue from U.S. sources.
How is Foreign Co.’s income taxed by the U.S. under either:
1) The current “deferral” international tax system?
2) The “territorial” tax system proposed by Mitt Romney and Newt Gingrich?
3) A more expansive “worldwide” tax system as proposed by President Obama.
Current ”Deferral” Tax System
Under the current system, there is generally no U.S. tax imposed upon the earnings of Foreign Co. until the earnings are repatriated to the U.S through a distribution to X Co. At that point, X Co. will pay U.S. tax on the dividend received from Foreign Co., subject to any tax treaty between X Co. and Foreign Co.’s resident nation.
Upon receiving the dividend, X Co. is permitted to utilize a foreign tax credit to reduce the U.S. tax applied to the dividend, preventing the same income from being taxed twice: once when earned by Foreign Co. and a second time when distributed to X Co.
- The current “foreign tax credit” system ensures that even where Foreign Co. enjoys a lower tax rate in its home nation, tax will ultimately be imposed on the earnings of Foreign Co. at the U.S. corporate rate;
- U.S. tax is not imposed upon income earned by F Co. until the earnings are repatriated to the U.S.
- An administrative nightmare;
- Encourages X Co. to leave Foreign Co.’s profits offshore to avoid the imposition of U.S. taxes upon repatriation;
- Gives birth to a wide variety of accounting tricks and sophisticated tax planning measures employed to minimize the U.S. tax burden, which ultimately reduce U.S. tax revenue.
Territorial Tax System
Under a territorial tax system, U.S tax would never be imposed on income earned by Foreign Co. from non-U.S. sources. The U.S. would simply allow Foreign Co.’s home country to tax its earnings. When Foreign Co.’s earnings are subsequently repatriated to X Co., the dividends would not be subject to U.S taxation.
- Greatly reduces the complexity of international taxation;
- Eases the administrative burden on multinational corporations;
- By eliminating the U.S. tax on repatriated foreign earnings, U.S. companies will no longer have to pay to bring overseas income “home,” thus encouraging investment in the U.S.
- Encourages U.S. corporations to shift activities to jurisdictions with lower corporate tax rates, taking jobs and revenue along with them and eroding the U.S. tax base.
- Transition concerns; What do you do with the foreign income that was previously earned but not yet repatriated to the U.S.?
A More Expansive Worldwide Tax System
President Obama is proposing a sea change in the way the U.S. taxes international operations; one which embodies the opposite characteristics of the system proposed by his Republican counterparts. The president would eliminate the current laws that permit domestic corporations to defer U.S. tax on Foreign Co.’s earnings until they are repatriated by instituting a worldwide minimum tax. This tax would be imposed on Foreign Co.’s income when earned, regardless of whether it was U.S. sourced or when it is repatriated.
- More tax revenue for us!
- Does not distort the decision of where to invest.
- Eliminates incentive to game the system, since the U.S. will tax Foreign Co.’s earnings, wherever they may be.
- Makes the existing administrative nightmare even worse;
- I’m not sure if this is a pro or con, but it is the opposite system that much of the developed world is adopting, potentially putting us at a competitive disadvantage.
- Is sure to be highly opposed by powerful corporations that have successfully shifted much of their earnings overseas under the current regime.
Which system is the best? It’s nearly impossible to say at this point, because under no scenario would the U.S. adopt a pure territorial or worldwide international tax system. Any territorial system would have to adopt elements of a worldwide system to curb abuses, and vice versa. As indicated above, there are advantages and disadvantages to each of the options, and ultimately, the devil will be in the details.
This much is clear, however; the chasm that exists between the proposals fronted by President Obama and the Republican candidates is material and meaningful, and stands to garner more attention as November nears.