By: James Redman
On Wednesday, September 27, 2017, the White House and Congressional Republicans revealed a new tax plan. Obtained and reported by the Washington Post, Congress released a nine-page document titled, “Unified Framework for Fixing Our Broken Tax Code,” which summarizes the proposed tax code reformations. With this tax plan, President Trump expects to bring “revolutionary change” to the United States, especially to the middle class and American businesses. One of the single greatest revisions that Congress’ plan proposes is the transition of the U.S. from a worldwide to a territorial based tax system. That is, the United States would depart from its position to tax U.S. citizens and corporations on worldwide income.
To better explain how the current worldwide tax system works, here is an example. Currently, a U.S. Corporation that receives a dividend from a foreign corporation will be taxed both in that foreign country and by the U.S. Under this worldwide system, a U.S. corporation is allowed to credit a portion of the foreign corporate income tax, or, “deemed to have paid” a portion of the foreign income tax, if the U.S. corporation owns at least 10% voting stock in the foreign corporation (S 902(A) of the Internal Revenue Code). In calculating this deemed to have paid amount, Section 902(A) of the Internal Revenue Code states that the U.S. taxpayer is to multiply Post-1986 foreign income taxes of the foreign corporation by the quotient of the dividend amount paid to the domestic corporation and Post-1986 undistributed earnings of the foreign corporation.
An example of the deemed-to-have-paid calculation is when a foreign corporation derives $1 million in earning before taxes, and pays $250,000 of foreign income taxes (based on that country’s tax rate) to it’s country of incorporation There is now $750,000 of after-tax earnings that the foreign corporation distributes as a dividend to the U.S. corporation. For this example, the foreign corporation distributes the entire $750,000 amount. Under a territorial-based tax system, this $750,000 would be untaxed foreign-source income for a U.S. taxpayer (the corporation). However, under a worldwide schema, a U.S. corporation’s tax liability would be as follows: $ 1 million in worldwide income ($750,000 dividend + $250,000 of gross-up income) multiplied by the U.S. corporate rate of 35% = $350,000. In turn, the $350,000 of U.S. tax – the $250,000 deemed paid amount would yield $100,000 (instead of the full $750,000) of U.S. tax liability. Confusing? I know.
In short, proponents of a territorial-based system would argue that a worldwide system incentivizes forum shopping and deferred payment of U.S. tax. By including a one-time repatriation tax, the proposed plan would “encourage companies to bring offshore profits back to the United States.” It may even be argued that territorial-based taxation does not distort competition through taxing corporations in a foreign country at the same rate, while not taxing them in their country of incorporation. However, there are issues that transitioning to a territorial tax system may raise. First, there is the looming threat of tax base erosion – where companies can avoid higher taxation and shift profits to low-tax rate foreign countries. Under a worldwide system, U.S. companies are going to be taxed at the U.S. rate regardless of where a foreign subsidiary or branch is located. Secondly, a territorial system would incentivize U.S. business to incorporate in any foreign country (since they will not be taxed by the U.S.), where as a worldwide system encourages companies to be cognizant of where they place branches/subsidiaries. Lastly, and perhaps most importantly, a worldwide-based taxation system benefits the U.S. through tax revenue. Using a territorial-based scheme would not increase the amount of revenue the United States receives annually. Although the transition to territorial taxation purports to encourage companies to bring foreign-sourced profits back to the U.S,, this is purely speculation. Moreover, the new tax proposal would leave it up to Congressional representatives to determine the repatriation tax rates for different assets.
There is an enormous volume of academic works and studies that lend support to either side of the income taxation debate ─ a worldwide-based taxation system versus a territorial-based system. Because of the extensive and often convoluted nature of tax law, I urge the Trump Administration and Congress to approach this tax plan with caution, rather than creating a tax plan that can be most aptly characterized as the fruit of expediency.