July 19,2017

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Tax Talk: What’s A Territorial Tax System?

Shifting The Current Structure Of The U.S. International Tax System Can Boost Competitiveness Of American Job Creators Around The Globe

Because of rapid changes in technology and communications, capital and labor, and many other assets like intellectual property have become easier to move across national borders. In today’s global economy, these types of mobile assets are far more responsive to comparatively high tax rates than ever before. 

This has had profound implications for international tax policy.

In recent years, there has been an uptick in U.S. inversions and foreign takeovers of U.S. companies, which has seriously eroded our nation’s tax base. While lowering the U.S. corporate tax rate from one of the highest in the world to one of the lowest will help ease these challenges and make American businesses more competitive, reforms to the structure of our the international tax system are another essential part of the equation.

What Is A Worldwide Tax System?
The U.S. currently operates under a worldwide system. Put simply, this means that a company incorporated in the United States pays corporate taxes on all of its income, whether earned here or overseas.

Income earned in America is taxed right away. Income earned abroad is taxed once the earnings are brought back to the United States. This is known as “deferral.” 

However, the fact that profits earned abroad are taxed when they are brought back to the United States often encourages American companies to keep their earnings offshore. This is known as the “lock-out effect.”

What Is A Territorial Tax System?
Under a territorial system, a U.S. multinational’s domestic income would be subject to the U.S. corporate tax, while the company’s foreign income would generally be exempt from U.S. tax. Operations abroad would only be subject to tax by the host country.

Most of America’s foreign counterparts use territorial tax systems, a far more competitive alternative.

Why Does This Matter?
A shift to a territorial tax system would help level the playing field for American companies in global markets. Last Congress, the Senate Finance Committee’s bipartisan tax reform working group on international taxes took a closer look at this issue.

The group, co-chaired by Senator Rob Portman (R-Ohio) and Senator Chuck Schumer (D-N.Y.) produced a report, which noted:

“In 1989, only 10 OECD [Organization for Economic Cooperation & Development] member countries had territorial tax systems and just two of the G-7 countries had such a system.  Today, 28 OECD countries and every other G-7 country has adopted some form of territorial system – and all of these countries have lower corporate tax rates than the United States.”

That same report went on to say,

“This means that no matter what jurisdiction a U.S. multinational company is competing in, it is at a competitive disadvantage.  The National Association of Manufacturers may have said it best in their submission [to the bipartisan International Income Tax Working Group]: ‘[i]f American companies cannot compete abroad, where 95 percent of the world’s consumers are located, the U.S. economy suffers from the loss of both foreign markets and domestic jobs that support foreign operations.”

The Bottom Line
Moving away from the worldwide type of tax system currently employed in the United States to tax the income of U.S.-based multinational corporations toward a territorial system would:

  • Modernize our tax system and help make American companies more competitive in the vast global marketplace;

  • Incentivize American companies to bring overseas earnings back to invest in their domestic operations, and without being taxed, eliminate the current incentive to keep those monies abroad; and

  • Create more jobs for American workers and promote growth in the U.S. economy.

Members of Congress from both parties support a shift to a territorial tax system. The idea was also included in the Trump administration’s principles for tax reform and is part of the conversation in current tax reform efforts.