Moving to a Territorial Income
Tax:
Options and Challenges
Jane G. Gravelle
Senior Specialist in Economic Policy
July 25, 2012
Congressional Research Service
7-5700
www.crs.gov
R42624
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service
Summary
Among
potential tax reforms under discussion by Congress is revising the tax
treatment of
foreign
source income of U.S. multinational corporations. Some business leaders have
been
urging
a movement toward a territorial tax, which would eliminate some U.S. income
taxes on
active
foreign source income. Under a territorial tax, only the country where the
income is earned
imposes
a tax. Territorial proposals include the Grubert-Mutti proposal (included in
President
Bush’s
Advisory Panel on Tax Reform proposal in 2005) and, more recently, a draft Ways
and
Means
Committee proposal and a Senate bill, S. 2091. The Fiscal Commission also
proposed a
territorial
tax. Proposals have, however, also been made to increase the taxation of
foreign source
income,
including S. 727, and proposals by President Obama.
Although
the United States has a worldwide system that includes foreign earnings in U.S.
taxable
income,
two provisions cause the current system to resemble a territorial tax in that
very little tax
is
collected. Deferral delays paying taxes until income is repatriated (paid as a
dividend by the
foreign
subsidiary to its U.S. parent). When income is repatriated, credits for foreign
taxes paid
offset
the U.S. tax due. Under cross-crediting, unused foreign tax credits from high
tax countries
or
on highly taxed income can be used to offset U.S. tax on income in low tax
countries.
Some
proponents of a territorial tax urge such a system on the grounds that the
current system
discourages
repatriations. Economic evidence suggests that effect is small, in part because
in
normal
circumstances a large share of income is retained for permanent reinvestment.
Amounts
held
abroad may have increased, however, as firms lobbied for another repatriation
holiday
(similar
to that adopted in 2004) that allowed firms to exempt most dividends from
income on a
one-time
basis. Opponents are concerned about encouraging investment abroad. A
territorial tax is
generally
not viewed as efficient because it favors foreign investment, but that increased
outflow
of
investment is likely to have a small effect relative to the U.S. economy.
Artificial shifting of
profits
into tax havens or low tax countries is a current problem that could be
worsened under
some
territorial tax designs, and proposals have included measures to address this
problem.
Proposals
also address the transitional issue of the treatment of the existing stock of
unrepatriated
earnings.
The Ways and Means proposal would tax this stock of earnings, but at a lower
rate, and
use
the revenues to offset losses from other parts of the plan, which would lead to
a long-run
revenue
loss. S. 2091 has a similar approach. The Grubert-Mutti proposal does not have
a specific
transitional
tax, but would raise revenue largely due to its disallowance of parent overhead
expenses
aimed at reducing profit shifting. The other two proposals also contain
provisions to
address
profit shifting.
In
addition there are complicated issues in the design of a territorial tax, such
as how to treat
branches
and dividends of firms in which the corporation is only partially owned. A
number of
issues
arise from the ending of foreign tax credits, with perhaps the most significant
one being the
increased
tax on royalties, which are currently subject to tax, have low or no foreign
taxes, and
would
lose the shield of excess credits.
The
final section of the report briefly discusses some alternative options,
including those in S.
727
and in the Administration proposals. It also discusses hybrid approaches that
combine
territorial
and worldwide systems in a more efficient way, including eliminating the
disincentive
to
repatriate. One such approach is a minimum tax on foreign source income, which
is proposed
by
the President in the context of current rules, but could be combined with a
territorial system.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service
Contents
Introduction.....................................................................................................................................
1
How
the International Tax System Works
.......................................................................................
2
Deferral.....................................................................................................................................
2
Profits
of Foreign Incorporated
Subsidiaries.......................................................................
3
Current
Payment Income.....................................................................................................
3
Branch
Income
....................................................................................................................
3
Subpart
F Income ................................................................................................................
3
Cross-Crediting.........................................................................................................................
4
Foreign
Tax Credit Limit Baskets
.......................................................................................
5
Separate
Limit on Oil and Gas
............................................................................................
5
Allocation
of Deductions
....................................................................................................
6
Title
Passage Rule
...............................................................................................................
6
Foreign
Tax Credit Splitting (Now Restricted)
................................................................... 6
The
Magnitude and Distribution of Foreign Source Income and Taxes, Actual and
Potential.......................................................................................................................................
7
Current
Sources of Realized Foreign
Income............................................................................
7
Deferred
Income........................................................................................................................
9
Sources
of Tax Liability
..........................................................................................................
10
Current
and Potential Tax
Collections.....................................................................................
12
Issues
in Considering Territorial Taxation
.....................................................................................
12
Effect
on Repatriations
............................................................................................................
13
Location
of
Investment............................................................................................................
16
Assessing
Arguments for A Territorial Tax
....................................................................... 16
Likely
Effects of International Tax Revision on
Investment............................................. 18
Treatment
of Royalties and Export Income.......................................................................
20
Artificial
Profit Shifting
..........................................................................................................
20
Transition................................................................................................................................
22
Administration
and
Compliance..............................................................................................
23
Revenue
Issues ........................................................................................................................
23
Design
Issues in a Territorial Tax
..................................................................................................
24
The
Grubert Mutti
Proposal.....................................................................................................
24
Ways
and Means Chairman Camp’s Discussion Draft
............................................................ 25
Senator
Enzi’s Bill (S. 2091)
...................................................................................................
27
Analysis
and Commentary on the Proposals
........................................................................... 28
Repatriation
Incentives......................................................................................................
28
Effects
on Tax Burden and
Investment..............................................................................
28
Artificial
Profit Shifting ....................................................................................................
30
Transition
..........................................................................................................................
34
Administrative
and Technical Issues
.................................................................................
35
Revenue
Consequences
.....................................................................................................
38
Alternatives
to a Territorial
Tax.....................................................................................................
38
Ending
Deferral
.......................................................................................................................
39
Ending
Deferral and Ending Cross-Crediting Via a Per Country Limit
.................................. 39
Measures
to Modify the Current System: the President’s
Proposals....................................... 39
Partial
or Targeted End to Deferral..........................................................................................
41
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service
Formula
Apportionment ..........................................................................................................
41
Hybrid
Approaches: Minimum Tax, Partial Territorial
Tax..................................................... 42
Tables
Table
1. Distribution of Foreign Source Income Realized in the United States by Type,
2007
and 2008
..............................................................................................................................
7
Table
2. Distribution of Realized Foreign Source Income
Before
Non-Allocable Deductions, 2007 and 2008......................................................................
8
Table
3. Foreign Tax Payments and Credits, 2007 and
2008......................................................... 10
Table
4. Estimated Sources of Tax Revenue on Foreign Source Income, 2000 ............................
11
Table
5. Current and Potential Tax Collections on Foreign Source Income,
FY2014................... 12
Table
6. Summary of Discussion in Text of Base Erosion Provisions of the Proposals
................ 31
Appendixes
Appendix.
History of International Tax Rules
...............................................................................
43
Contacts
Author
Contact
Information...........................................................................................................
43
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 1
Introduction
Tax
reform is a perennial issue before Congress. One area of increasing attention
is the taxation
of
U.S. companies on the income they earn abroad. Recently, proposals have been
made to, in
some
cases, decrease taxes and in others to increase these taxes.
Businesses
leaders have been urging a movement toward a territorial tax, which would
generally
eliminate
U.S. income taxes on active foreign source income. Such a proposal (presumably
based
on
one developed by Grubert and Mutti) was included in the President’s Advisory
Panel on Tax
Reform
in 2005,1 more recently in a draft proposal by Ways
and Means Committee Chairman
Dave
Camp,2 and in a bill, S. 2091, introduced by
Senator Enzi. The National Commission on
Fiscal
Responsibility and Reform (referred to as the Fiscal Commission) also proposed
a
territorial
tax in general terms.3
Proposals
have also been made to move in the opposite direction and increase the taxation
of
foreign
source income, including S. 727, introduced by Senators Wyden and Coats, which
would
use
the significant revenues gained to help finance a corporate income tax rate
cut. President
Obama
has included increased taxes on foreign source income in his budget outlines
and, more
recently,
in his framework for business tax reform, as a revenue source for rate
reduction.4
Because
of various features in the current tax system, the U.S. tax system already
bears a close
resemblance,
in terms of revenue collected, to a territorial tax. Tax on the income of
foreign
subsidiaries
is deferred until repatriated (paid as dividends to the U.S. parent) and tax
can be
avoided
by not repatriating income. The system limits credits claimed for foreign taxes
paid to
U.S.
tax on foreign income. The limit, however, is on an overall basis, permitting
unused credits
from
high-tax countries to shield income from low-tax countries, or income that
bears little
foreign
tax, from being taxed in the United States. Because firms have flexibility in
timing
repatriations,
the residual effective tax rate on foreign income is estimated at only 3.3%.5 Some
types
of income, such as royalties, are treated more favorably under the current
system than they
would
be under a territorial tax.
1 The President’s Advisory Panel on Federal
Tax Reform, Final Report, November 1, 2005, at
http://govinfo.library.unt.edu/taxreformpanel/final-report/index.html.
The Grubert-Mutti proposal was the territorial
proposal under discussion for a number of years. It is outlined
in Harry Grubert and John Mutti, Taxing International
Business Income: Dividend
Exemption Versus the Current System (Washington,
DC, AEI Press, 2001). It is discussed
in further detail in Rosanne Altshuler and Harry Grubert, “Where
Will They Go if We Go Territorial? Dividend
Exemption and the Location Decisions of U.S. Multinational
Corporations,” National Tax Journal (December 2001),
pp. 787-809. Because the current U.S. tax system collects little
revenue, and because of features of the Grubert-Mutti
proposal to allocate parent company deductions, this proposal
would raise revenue.
2 See various discussions and drafts at the
Ways and Means Committee website, at http://waysandmeans.house.gov/
taxreform/.
3 The National Commission on Fiscal
Responsibility and Reform, The
Moment of Truth, at
http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/TheMomentofTruth12_1_2010.pdf.
4 The President’s Framework for
Business Tax Reform: A Joint Report by the White House and the Department of
the
Treasury, February 2012, at
http://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-
Framework-for-Business-Tax-Reform-02-22-2012.pdf.
5 Melissa Costa and Jennifer Gravelle,
“Taxing Multinational Corporations: Average Tax Rates,” presented at a
Conference of the American Tax Policy Center, October 2011, and
forthcoming in Tax Law Review at
http://www.americantaxpolicyinstitute.org/pdf/Costa-Gravelle%20paper.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 2
Economists
have traditionally analyzed the foreign tax system in terms of economic
efficiency.
Economic
theory tends to support, on efficiency grounds, a worldwide system in which
income
from
U.S. investment earned abroad is subject to the same tax, or as close to the
same tax as
possible,
as that on domestic investment. It does not support a territorial tax, and most
proposals
in
the past were to move closer to an effective worldwide tax (see Appendix).
At the same time,
if
such a change is not feasible, another question becomes whether moving to an
explicit
territorial
tax would be better or worse than the present system. The fundamental issues are
• the
effects on disincentives to repatriate income,
• to
what extent the revision will divert investment from the United States,
• the
effects on artificial profit shifting,
• transition
issues,
• administrative
and compliance considerations, and
• the
revenue consequences.
There
is no single blueprint for a territorial tax and the answers to these questions
depend, to
some
extent, on specific design choices.
This
report first explains how the international tax system works and describes the
magnitude and
distribution
of foreign source income and taxes. The report then focuses on alternative
features of
a
territorial tax and their consequences. It also contains, in a final section, a
brief discussion of
options
that move in the opposite direction and other alternatives that do not fit into
either the
territorial
or worldwide approach (such as current taxation of foreign source income but at
a
lower
rate).6
How the International Tax System
Works
The
current U.S. tax system is a hybrid. It has some elements of a residence-based
or worldwide
tax,
where income of a country’s firms is taxed regardless of its location. It also
has some
elements
of a source based or territorial tax, where all income earned within a country
is taxed
only
by that country regardless of the nationality of the firms. The provisions that
introduce
territorial
features are deferral and cross-crediting. There are a number of complex
interactions
that
will affect both the design of a territorial or other tax revision and the
consequences of those
changes.
Deferral
Deferral
allows a firm to delay taxation of its earnings in foreign subsidiaries until
the income is
paid
as a dividend to the U.S. parent company. Although a territorial tax is often
focused on
exempting
foreign source income that under current law is taxed when repatriated, there
are four
basic
categories of foreign source income, three of which are not eligible for
deferral. They are
6 Fundamental economic issues are discussed
in CRS Report RL34115, Reform of U.S. International
Taxation:
Alternatives, by Jane G. Gravelle.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research Service
3
profits
of foreign incorporated subsidiaries; current payment income, such as royalties
and
interest
payments; branch income; and Subpart F income.
Profits of Foreign Incorporated
Subsidiaries
U.S.
multinationals are not currently taxed on the profits of their subsidiaries
incorporated abroad
(except
for “Subpart F Income” discussed below). Rather they defer payment of taxes
until the
income
is received by the parent as a dividend (repatriated). U.S. tax is then due on
the dividend
and,
because the dividend is after foreign tax, an additional amount (called a
gross-up) is added to
taxable
income to reflect the foreign taxes paid and place the income on a pre-tax
basis.7 A
foreign
tax credit is then allowed against this U.S. tax.
Current Payment Income
Current
payment income is income that is received as a direct payment, such as
royalties and
interest.
It is taxed currently. This income is usually deductible as an expense in the
foreign
country
and, indeed, may not constitute true foreign source income, at least in the
case of
royalties
that could be viewed as more like export income.
Branch Income
Branch
income is income from operations that are carried out without a separately
incorporated
foreign
subsidiary. Income of operations organized as foreign branches rather than as
separately
incorporated
subsidiaries is also taxed currently. For tax purposes, branch gross income and
deductions
are combined with parent income just as if the operation were taking place in
the
United
States. Although branch income is not eligible for deferral, it can be a
beneficial form of
organization
in some cases. If a firm is experiencing a loss, which may be the case with
start-ups
or
mineral or exploration companies, the losses can only reduce U.S. income if the
operation is in
branch
form. In some cases, dividends may attract an additional withholding tax,
although for
most
trading partners these taxes are eliminated or minimized through tax treaties.
Non-tax
reasons
may also cause a firm to choose the branch form; this form, for example, may be
particularly
beneficial for financial firms in which the branch operation is backed by the
assets of
the
worldwide firm.
Subpart F Income
Subpart
F income, named after the section of the Internal Revenue Code that imposes the
rules, is
income
that can easily be shifted to low tax jurisdictions. Subpart F income includes
passive
income,
such as interest and dividends, and certain sales and service income flowing
between
7 This discussion generally refers to foreign
subsidiaries that are sometimes wholly owned and sometimes partially
owned by a U.S. parent. The tax law defines a controlled foreign
subsidiary or a controlled foreign corporation (CFC)
as one in which the U.S. firm has a 10% share and 50% of the
shares are owned by five or fewer 10% U.S.
shareholders. A corporation in which a U.S. firm owns a 10%
share but 50% is not owned by five or fewer 10%
shareholders is called a non controlled Section 902 corporation
or a 10/50 corporation. Smaller share ownership is
portfolio investment. New data from the Internal Revenue Service
reports dividends from firms that are less that 20%
owned, more than 20% owned and wholly owned at 7%, 65%, and 27%,
although any of these firms could potentially
be CFC’s and the payout ratios may differ. Filled in 1120 form
at http://www.irs.gov/pub/irs-soi/08colinecount.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 4
related
parties (called foreign base company income). This income is taxed currently.
Subpart F
has
been made less effective in recent years because of check-the-box rules that
allow flexibility
in
choosing whether to recognize related firms as separate entities.8 There are also specific
exceptions
to Subpart F rules that allow for income from active financing and insurance
operations
that might otherwise fall under Subpart F to be deferred. These provisions are
currently
part of the “extenders,” provisions that are enacted with an expiration date
but that are
generally
extended periodically. The extenders have currently expired after 2011,
although some
or
all of them they may be extended retroactively. Also among the extenders is a
look-through
rule
that has a similar effect to check-the-box through legislative rather than
regulatory rules.9
Cross-Crediting
Cross-crediting
is a phenomenon that occurs when credits for taxes paid to one country can be
used
to offset U.S. tax due on income earned in a second country. Cross-crediting
occurs because
countries
generally tax all income arising within their borders from both foreign and
domestic
firms.
The U.S. system allows a credit against U.S. tax due on foreign source income
currently
taxed
for foreign income taxes. This foreign tax credit is designed to prevent double
taxation of
income
earned by foreign subsidiaries of U.S. corporations from facing a combined U.S.
and
foreign
tax in excess of the U.S. tax due if the income was earned in the United
States. In addition
to
cross-crediting across countries, cross-crediting can occur within a country if
some income is
subject
to high tax rates and some is subject to lower tax rates.
If
the foreign tax credit had no limit, a worldwide system with current taxation
and a foreign tax
credit
would produce the same result, for firms, as a residence based tax, because the
tax
effectively
applying would be the tax of the country of residence. Firms in countries with
a higher
rate
than the U.S. rate would get a refund for the excess tax, and firms in
countries with a lower
rate
than the U.S. rate would pay the difference. To protect the nation’s treasury
from excessively
high
foreign taxes causing excessive revenue losses, however, the credit is limited
to the U.S. tax
that
would be due on the foreign source income. If applied on a country-by-country
and incomeby-
income
basis, this rule would result in higher taxes paid on incomes and/or in
countries where
foreign
taxes are higher than U.S. taxes. The rule would also result in total taxes
paid equal to the
U.S.
tax when foreign taxes are lower. If applied overall or in a way that can
combine income
subject
to high taxes with income subject to low taxes, unused credits in high-tax
countries (or
associated
with highly taxed income) can be used to offset U.S. tax due in low-tax
countries or
income
subject to low taxes. This mechanism is called cross-crediting.
Cross-crediting
is important to consider when evaluating international tax changes, including
the
move
to a territorial tax, because cross-crediting would largely disappear with the
disappearance
of
foreign tax credits associated with exempted income. Excess credits could no
longer shield
certain
direct active income such as royalties from U.S. taxes.
8 Check-the-box allows a firm, including a
subsidiary of a U.S. firm, to choose to disregard (not recognize) its own
subsidiary as a separate entity and consolidate that income with
the parent (higher tier subsidiary) firm. For example, if
a U.S. parent’s subsidiary in a low-tax country lends money to
its own subsidiary in a high-tax county (with deductions
for interest paid), the interest income received by the low-tax
subsidiary would normally be taxed as Subpart F income
even if this income is not repatriated to the U.S. parent.
Check-the-box allows the high-tax subsidiary to be disregarded
for tax purposes so that no interest income appears.
9 See David R. Sicular, “The New Look-Through
Rule: W(h)ither Subpart F?” Tax
Notes, April 23, 2007, pp. 349-378
for a discussion of this provision.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 5
A
variety of tax rules can affect the degree and nature of cross-crediting:
separating income and
credits
into baskets with cross-crediting only allowed within the basket;
characterizing certain
royalty
and export income as foreign source; restricting the use of excess credits
generated from
oil
and gas extraction; and interest and other expense allocation rules. In
addition, a provision that
effectively
allowed claiming of foreign tax credits when the associated income was not
subjected
to
U.S. tax, termed foreign tax credit splitting, may have affected past practices
and data. This
provision
was restricted in 2010.
Firms
whose foreign tax payments are larger than those permitted to be credited under
the foreign
tax
credit limit rules are said to be in an excess credit position. Firms whose tax
payments are
smaller
are in an excess limit position.10
Foreign Tax Credit Limit Baskets
While
the United States has had a variety of limit rules in the past,11 it currently has an overall
limit
that allows cross-crediting, separated into two significant baskets based on
the type of
income:
an active or general basket and a passive basket. About 95% of income is in the
general
basket
so there is much scope for cross-crediting.12
Therefore, companies that have paid taxes
higher
than the U.S. rate can still (within each basket) offset U.S. taxes on income
earned in lowtax
countries.
Higher tax rates can also offset taxes on income generally taxed at low or no
rates;
one
example is royalties associated with active operations, which fall in the
active basket and may
be
shielded from U.S. tax by excess foreign tax credits. Another is foreign source
income from
export
sales, discussed below under the “Title Passage Rule.”
Separate Limit on Oil and Gas
The
law also contains separate restrictions on certain other types of income, one
of importance, as
measured
by foreign income affected, being oil and gas extraction income. A separate
provision
disallows
credits paid on oil and gas extraction income in excess of the U.S. tax due,
although
they
can be carried over to future years. This treatment has the effect of placing
oil and gas
extraction
income in a separate basket, because generally this income is subject to high
foreign
taxes.
For example, if the U.S. tax on foreign oil and gas extraction income is 35%
and the
foreign
tax is 50%, the extra 15% credit cannot be used to offset tax on other income.
This
treatment
has the same effect as placing this oil and gas extraction income in a separate
basket. If
the
tax on oil and gas extraction income were lower than the U.S. tax, this income
would be
eligible
to have the additional U.S. tax offset by excess credits on other income
because income
from
oil and gas extraction income is not actually in a different basket.
10 Fewer excess credit firms in recent years
also led to transactions designed to generate foreign tax credits, but these
have now been limited by regulation. See Steven Schneider,
Regulations Address Foreign Tax Credit Generator
Structures, at
http://www.taxlawroundup.com/2011/07/regulations-address-foreign-tax-credit-generator-transactions/.
11 A per country limit was used in the past at
various times, but because it did not have look-through rules, holding
companies could be used to accomplish the effects of an overall
limit. While an overall credit limit has been used for
some time, between 1986 and 2004, the credit was applied within
nine different baskets.
12 Scott Luttrel, “Corporate Foreign Tax
Credit, 2007,” Internal Revenue Service, Statistics
of Income Bulletin, 2011, at
http://www.irs.gov/pub/irs-soi/11cosumbulcorpforeign.pdf. There
are two very small baskets for income from countries
sanctioned by the United States and income resourced by treaty,
which accounted for less than two-tenths of a percent.
Prior to 2007 when there were nine baskets, but the only
important difference was a separation of the financial services
basket, with 19.7% of income, from the general basket.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 6
Allocation of Deductions
Another
feature that may contribute to the generation of excess foreign tax credits is
the
allocation
of overhead and other deductions that are not taken for foreign tax purposes.
While
many
deductions can be traced to a particular source of income, the parent firm’s
costs for
interest,
research, and other overhead (e.g. administration) is allocated between
domestic and
foreign
uses for purposes of the foreign tax credit limit. This allocation lowers the
amount of
foreign
source income. Because these reductions in income are not recognized by the
foreign
jurisdiction,
the result could be to generate excess credits, even in countries whose general
effective
tax rate is actually lower than that of the United States.
These
allocations are necessary for determining net income by source. Borrowing is
generally
done
at the parent level. In addition, the interest allocation limits the ability of
firms who are in
the
excess credit position to avoid U.S. tax by borrowing in the United States rather
than in lowtax
countries
where the deduction is less valuable.
The
rule, however, has some imperfections. Foreign subsidiaries may also have
overhead costs,
particularly
interest, which are not recognized in income because dividends are received net
of
deductions.
In 2004, a revision that would have allowed elective allocation of worldwide
interest,
was
adopted but did not go into effect immediately. This elective worldwide
interest allocation
rule
has been delayed on several occasions; currently it is scheduled to take place
in 2021.
Title Passage Rule
There
is a special rule called the title passage rule (or the inventory sales source
exception rule)
that
allows half of manufacturing export income (and all of sales of inventory) to
be sourced as
income
in the country in which the title passes. Because this title passage can be
arranged in
foreign
countries, this income is foreign source income and thus eligible for
cross-crediting. This
provision
is effectively an export subsidy for firms with excess foreign tax credits. The
title
passage
rule is important in considering a territorial tax because cross-crediting, at
least for active
income,
would, in theory, disappear. Export income, as well as royalties, would be
subject to
higher
tax rates in some cases with elimination of foreign tax credits.
Foreign Tax Credit Splitting
(Now Restricted)
Prior
to 2010, there was also a possibility of claiming foreign tax credits for
income that had not
actually
been subject to tax due to differing rules across countries as to entity
status.13 P.L. 111-
226
disallowed any consideration of a foreign tax credit unless the underlying
income was
reported.
Although this provision was estimated to gain relatively little revenue (about
$0.4
billion
annually),14 it is hard to be certain how prevalent
these activities were. These arrangements
13 These treatments were referred to as
reverse hybrids, and they occurred when, from the U.S. perspective, the
subsidiary has its own subsidiary where profits can be deferred,
but from the foreign perspective the subsidiary and its
own subsidiary are the same firm. The top tier subsidiary thus
confronts a foreign tax it is liable for and which could be
claimed as a credit even though the income is not reported
because it is eligible for deferral. It is the reverse of the
check the box arrangement.
14 This provision was adopted in the P.L.
111-226. See Joint Committee on Taxation,
General Explanation Of Tax
Legislation Enacted In The 111th Congress, JCS-2-11, March 24, 2011, for the revenue estimate for this
provision and
for several other revisions of the foreign tax credit to address
abuses. See also CRS Report R40623, Tax
Havens:
International Tax Avoidance and
Evasion, by Jane G. Gravelle.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 7
may
affect the data currently available by increasing the ability of firms to
offset, for example,
royalties
with excess credits.
The Magnitude and Distribution
of Foreign Source
Income and Taxes, Actual and
Potential
Before
discussing the issues and consequences of reforms, it is useful to get a “lay
of the land.”
How
important are the various sources of foreign income, how much tax do they
generate
currently,
and how much might they generate with various reforms? Because individual tax
return
data
are not available, this issue can only be explored by combining aggregate data
available and
various
analyses that have been done by researchers with access to tax returns. This
section
discusses
the current sources of foreign income, the potential magnitude of foreign
income not
reported,
the sources of tax liability, and the potential size of foregone taxes due to
deferral and
cross-crediting.
Current Sources of Realized
Foreign Income
Table
1 shows the distribution of foreign source income by type for
firms claiming and receiving
foreign
tax credits for 2007 and 2008, to the extent that sources can be identified.
This data set
should
capture most of foreign source income reported by U.S. multinationals on their
tax return
(i.e.,
not deferred). (Although some data are available for 2009, these data may be
skewed
because
of the economic slowdown that spread abroad). Total foreign source net income
was
$392.5
billion in 2007 and $413.4 billion in 2008. In the data, oil and gas extraction
income is
reported
separately, so that dividends do not include that income.
Table
1. Distribution of Foreign Source Income Realized in
the
United States by Type, 2007 and 2008
Type of Income
Share of Taxable
Income, 2007 (%)
Share of Taxable
Income, 2008 (%)
Dividend Payments 19.2 22.2
Includable Income (Subpart F) 16.6 16.5
Deemed Taxes (Gross Up) 12.9 16.9
Export Income 3.7 3.5
Royalties, and License Payments (Gross) 26.0 25.7
IC-DISC 2.3 0.0
Other 19.4 15.2
Source: Statistics of
Income, International Statistics, Returns With Foreign Tax Credits,
http://www.irs.gov/
taxstats/bustaxstats/article/0,,id=210069,00.html; Royalties and
License Payments adjusted to eliminate rents
based on data from Bureau of Economic Analysis, Trade in Services,
1999-2010, http://www.bea.gov/scb/pdf/
2011/07%20July/0711_itaq-tables.pdf. Foreign taxes withheld as
reported in the IRS data are added to royalties.
Total taxable income for royalties from the Commerce Department
data was increased by withholding taxes of
approximately $4 billion.
Notes: Newly provided
data for 2008 and 2009 separate the deemed tax gross up; for 2008, 73% of these
taxes
were associated with dividend payments and the remainder with
Subpart F. See Internal Revenue Service
http://www.irs.gov/pub/irs-soi/08colinecount.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 8
Note
that the third item in the table is related to the first two. Because dividends
and Subpart F
income
are on an after-tax basis, the dividends must be increased by the taxes paid
for corporate
taxpayers
electing a foreign tax credit. Most of the deemed paid taxes are probably
associated
with
dividend payments (73% for 2008 when data first because available)15 because Subpart F
income
is usually subject to lower foreign taxes. Accordingly, the data suggest an
estimate of
30%
to 35% of foreign source income that arises from these dividends.
The
table also shows that royalties are significant parts of foreign source income,
accounting for
about
a quarter of foreign source income, suggesting that the consequences of changes
in the law
for
this income might be significant.
In
Table 1,
the measure of net income was income net of all deductions (but before
adjustments).
Some
of these deductions were overhead costs that are allocated based on formulas.
In Table 2,
shares
are calculated based on income before these allocated deductions. With this
approach, it is
also
possible to calculate the share of interest income and oil and gas extraction
income. In Table
2,
foreign source income before non-allocable deductions is $615.4 billion in 2007
and $614.6
billion
in 2008. Non-allocable deductions accounted for 36% of this income in 2007 and
33% in
2008.
Table
2. Distribution of Realized Foreign Source Income
Before
Non-Allocable Deductions, 2007 and 2008
Type of Income
Share of Taxable
Income, 2007 (%)
Share of Taxable
Income, 2008 (%)
Dividend Payments 12.2 14.9
Includable Income (Subpart F) 8.3 11.1
Deemed Taxes (Gross Up) 10.6 11.4
Export Income 2.3 2.3
Royalties, and License Payments (Gross) 16.6 17.3
IC-DISC 1.4 0.0
Oil and Gas Extraction Income 10.2 15.9
Service Income 2.8 3.2
Interest 21.3 18.4
Other (rents, other branch income) 14.3 5.3
Source: Statistics of
Income, International Statistics, Returns With Foreign Tax Credits,
http://www.irs.gov/
taxstats/bustaxstats/article/0,,id=210069,00.html; Royalties and
License Payments adjusted to eliminate rents
based on data from Bureau of Economic Analysis, Trade in Services,
1999-2010, http://www.bea.gov/scb/pdf/
2011/07%20July/0711_itaq-tables.pdf. Foreign taxes withheld as
reported in the IRS data are added to royalties.
Total taxable income for royalties from the Commerce Department
data was increased by withholding taxes of
approximately $4 billion.
Notes: Newly provided
data for 2008 and 2009 separate the deemed tax gross up; for 2008, 73% of these
taxes
were associated with dividend payments and the remainder with
Subpart F. See Internal Revenue Service
http://www.irs.gov/pub/irs-soi/08colinecount.pdf.
15 See Internal Revenue Service
http://www.irs.gov/pub/irs-soi/08colinecount.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 9
Dividend
payments and their related tax gross ups are smaller as a share (25% to 30%)
when pretax
income
is considered. Their true importance probably lies somewhere between the shares
in
Table
1 and Table 2 given
the imperfections in allocation rules. Note however, that oil and gas
extraction
income can arise from a subsidiary and is simply reported separately. Including
oil and
gas
income in dividends would bring the totals back up toward 35% to 40% of income.
Oil and
gas
extraction income, however, has little or no reason not to be repatriated
because the taxes due
on
these earnings are generally larger than the U.S. tax (which is why they are
treated separately
in
a way that effectively results in a separate basket). Table
2 also shows the importance of
interest
income in the totals for foreign source income (although a full measure of the
importance
of
interest would require information on income of financial institutions through
branches).
Deferred Income
Table
1 and Table 2 report
realized income (direct, repatriated, branch, and Subpart F). Total
foreign
source income also includes deferred income. How large is this deferred income
on an
annual
basis? Estimates in this section indicate that close to half of foreign source
income is
subject
to U.S. tax, but less than a quarter of active income of foreign subsidiaries
of U.S. firms
that
can be deferred is currently repatriated.
There
are no precise data sources to estimate this effect. Based on IRS statistics
for controlled
foreign
corporations, available for 2008, which accounted for $177 billion of
distributions out of
pre-tax
income to U.S. parents (about 78% of the total distributions), total deemed and
distributed
income
was 27% of total pre-tax income. Subpart F income was 12.1% of pre tax income
and
dividends
were 14.7%.16 As a share of after tax income, dividends
were 18.1% of income and
Subpart
F 14.3% income, for a total of 32.4%. These ratios might be somewhat
understated
because
of the possibility of non-U.S. shareholders, but that is likely to be
unimportant.
Commerce
Department data (Table 6.16D: Corporate Profits by Industry) reports $511
billion and
$582
billion of rest of world corporate profits in 2007 and 2008, on an after-tax
basis.17
Considering
distributions after foreign tax in 2007, the ratios are 14.7% for dividends and
12.7%
for
Subpart F income, for a total of 27.4%. These ratios are 15.7% for dividends,
12.0% for
Subpart
F, and 27.8% for the total for 2008.
These
numbers do not capture deemed taxes. Using IRS data on controlled foreign
corporations
and
based on the ratios of deemed taxes to distributions in Table
1 (with 73% of deemed taxes
associated
with active dividends), the share of pre-tax profits including taxes for 2008
was 19.7%
for
dividends and 14.7% for Subpart F. Because Subpart F is not voluntary, the
share of dividends
out
of pre-tax profits net of Subpart F income is 23%.
A
study of the new M-3 form that reconciles tax and book income finds that for
firms with
positive
taxable and book income, 9% of the foreign source income is actively paid as a
dividend
and
47% is subject to U.S. tax (including royalties and other direct). Dividends as
a share of total
income
are 19%, the same share as in Table 1.
The ratios would be similar to those above if
deemed
taxes were included.
16 Internal Revenue Service, Statistics of
Income, Controlled Foreign Corporations, at http://www.irs.gov/taxstats/
bustaxstats/article/0,,id=96282,00.html. Firms represented in
these statistics have a 50% ownership or more.
17 Department of Commerce, Bureau of Economic
Analysis, Table 6.16D, at http://www.bea.gov/international/
di1usdop.ht.m.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 10
Overall,
it appears that close to half of foreign source income is reported as taxable
income in the
United
States, but less than a quarter of the income over which firms have discretion,
active
income
of foreign subsidiaries, is subject to U.S. tax. Rates of deferral vary
significantly by
location.
For 2008, in the aggregate 33% of after tax income of controlled foreign
corporations
was
distributed, 18% as discretionary dividends and the remaining 15% as Subpart F
income.
Canadian
subsidiaries, however, distributed 44%, with 36% as discretionary payments and
the
remaining
8% as Subpart F. However, for Switzerland, a significant tax haven country, 19%
was
paid
out, 10% as dividends and the remaining 9% as Subpart F. These shares are not
available for
2007,
and 2006 is probably not very representative, at least for tax haven countries,
because it
was
immediately after the repatriation holiday enacted in 2004 that permitted a
one-time dividend
payment
with an 85% exclusion.18
In
determining the consequences of present and proposed systems, it is also
important to note the
repatriated
income is not random. Firms presumably choose to repatriate income that can be
most
easily
shielded by foreign tax credits. Some evidence of this effect can be found in
the M-3 study,
in
which the residual U.S. tax on foreign source income was only 3.3% even though
half of
income
was reported and a significant share was in royalties that had little foreign
tax (to be used
for
credits) attached.
Sources of Tax Liability
To
examine this issue, consider the data in Table
3 on foreign tax credits, which indicate the
foreign
taxes paid, and credits claimed.
Table
3. Foreign Tax Payments and Credits, 2007 and 2008
Item 2007 ($ billions) 2008 ($ billions)
Current Foreign Taxes Paid 99.1 156.2
Minus Reduction (Largely for Oil and Gas Taxes) 10.3 14.7
Plus Carryover 29.2 49.7
Equals Total Foreign Tax Credits Available 117.9 191.2
Foreign Tax Credit Limit 114.0 122.5
Foreign Tax Credits Claimed 86.5 100.4
Residual U.S. Tax (Limit Minus Claim) 29.5 22.1
Source: Statistics of
Income, International Statistics, Returns With Foreign Tax Credits,
http://www.irs.gov/
taxstats/bustaxstats/article/0,,id=210069,00.html.
Even
though a significant share of the income was royalties and other direct income
that should
have
been taxed, the effective U.S. residual tax rate on foreign source income as
measured for tax
purposes
was only 7% in 2007 and 5% in 2008.19
Moreover, the size of the tax suggests that
royalties
were being shielded from tax by excess credits. The royalties were $101.9
billion and
$106.4
billion. Had they been fully subject to a 35% tax rate the tax on this source
of income
18 For 2006 total payments were 25% with 12%
as discretionary dividends. The data for Canada were similar, but in
Switzerland 16% was paid out in total but only 3% as dividends.
19 Residual U.S. tax in Table 3 divided by net income from statistics reported in Table 1.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 11
(offset
by approximately $4 billion in withholding taxes) would have been around $32
billion and
$33
billion respectively, larger than total taxes paid.
The
indication that royalties are shielded from tax is reinforced by evidence from
2000 tax
returns,
which traced the $12.7 billion of U.S. residual taxes to foreign sources.20 Table 4 shows
the
distribution of the shares paid. In 2000, there were nine foreign tax credit
limit baskets. Only
three
accounted for a significant share: passive (4.6% of the total), financial
services (21.3% of
total),
and the residual general limit basket (71.3% of the total).21 Active dividends in the general
basket
accounted for only 10.2% of total taxes and dividends in financial services
accounted for
2.4%.
The largest share was due to royalties, interest, and branch income in the
active basket.
Financial
branch income and financial interest each accounted for 18% so that the
financial
income
basket bore a share of taxes out of proportion to its share of income,
presumably in part
because
interest income was subject to tax. The remainder, 16.5% was due to the passive
basket,
which
was largely composed of Subpart F income.
Table
4. Estimated Sources of Tax Revenue on Foreign Source Income, 2000
Type of Income Share of Taxes Paid (%)
Dividends Non-Financial Services 10.2
Dividends Financial Services 2.4
Active Royalties, Interest and Export (Non-Financial) 33.9
Financial, Branch Income 18.1
Financial, Interest 18.1
Passive (Largely Subpart F) 16.5
Source: Harry Grubert and
Rosanne Altshuler, “Corporate Taxes in the World Economy: Reforming the
Taxation of Cross-border Income,” in Fundamental Tax Reform: Issues, Choices, and Implications, Ed. John W.
Diamond and George R. Zodrow, Cambridge, MIT Press, 2008, pp.
326-327.
If
current taxes were distributed in the same manner now as they were in 2000,
then taxes on
active
dividends for 2007 would have been responsible for a residual U.S. tax of
around one-half
of
1% on total foreign source active income potentially paid out as dividends.22 The combination
of
selective deferral and cross-crediting appears to have essentially eliminated
any U.S. tax on
active
income of foreign subsidiaries.
The
same study that estimated data for Table 4 estimated
that two-thirds of royalties were
shielded
by tax credits. It is possible, however, that more tax is collected on royalties
currently
because
of the declines in foreign tax rates and the elimination of foreign tax credit
splitting.
20 Harry Grubert and Rosanne Altshuler,
“Corporate Taxes in the World Economy: Reforming the Taxation of Crossborder
Income,” in John W. Diamond and George R. Zodrow, eds., Fundamental Tax Reform: Issues,
Choices, and
Implications (Cambridge: MIT Press, 2008).
21 Data on distribution by basket from Scott
Luttrell, Corporate Foreign Tax Credit, 2000, Internal Revenue Service,
Statistics of Income, at http://www.irs.gov/pub/irs-soi/00cftcar.pdf.
22 Pre-tax income would range from $112
billion for 2007 to $142 billion for 2008 (with deemed tax apportioned 73%
on active dividends. 12.6% of the total tax in Table 3 would result in $3.7 billion in 2007 and $2.8 billion in 2008,
for
an effective tax rate of 3.3% and 1.6% on dividends received.
However, estimates above indicate that only about 23%
of dividends are paid out, so that these tax rates need to be
multiplied by 0.23, yielding rates of 0.36% to 0.76%.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 12
Current and Potential Tax
Collections
To
consider a year that should be more normal (i.e., past the effects of a slow
recovery from the
recession)
Table 5 estimates
three components of potential foreign taxes for FY2014: foreign
taxes
projected to be collected, additional taxes collected as a result of the repeal
of deferral, and
additional
taxes collected if, in addition to repealing deferral, a per country foreign
tax credit
were
imposed. Those provisions taken together should result in a close approximation
of a true
worldwide
system that eliminated deferral and largely eliminates cross-crediting.
Table
5. Current and Potential Tax Collections on Foreign Source Income, FY2014
Provision
Effect on Revenues
($billions)
Share of Current Total
U.S. Corporate Tax (%)
Current Tax 32.1 7.5
Gain from Ending Deferral 18.4 4.3
Additional Gain from Per Country Foreign Tax Credit
Limit
45.9 10.9
Total Share of All 96.4 22.5
Addendum: Eliminate Title Passage Rule 6.3 1.6
Addendum: Repeal Worldwide Interest Allocation 3.6 0.8
Source: Current Tax
extrapolated from 2007 data based on changes in corporate tax revenues. Gain
from
Ending Deferral and Title Passage Rule from Joint Committee on
Taxation, Estimates Of Federal Tax
Expenditures
For Fiscal Years 2011-2015, January 17, 2012, JCS-1-12. Gain from Per Country Foreign Tax
Credit Limit from
Joint Committee on Taxation estimates at
http://wyden.senate.gov/imo/media/doc/Score.pdf; Worldwide interest
allocation based on FY2019 cost adjusted to FY2014 based on
projected corporate tax revenues; FY2019 cost at
Joint Committee on Taxation, General
Explanation Of Tax Legislation Enacted In The 111th Congress, JCS-2-11,
March 24, 2011.
This
table shows the importance of cross-crediting, by showing the effects of moving
to a per
country
foreign tax credit limit given deferral is eliminated. Because of this
importance, a
territorial
tax, which would eliminate foreign tax credits, can have consequences beyond
the
active
income it is designed to remove from the U.S. tax base, since excess credits
currently
shield
royalty and export income from U.S. tax.
Table
5 also shows the separate revenue consequences of two other
provisions: the title passage
rule
and the effect of worldwide allocation of foreign source income.
Issues in Considering
Territorial Taxation
Several
issues arise when considering moving from the present hybrid tax system to a territorial
tax:
the effect on repatriations, the effect on the location of real investment, the
consequences for
artificial
profit shifting, transition, administrative and compliance issues, and the
revenue
consequences.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 13
Effect on Repatriations
One
criticism of the current system is that while collecting very little revenue
from foreign
subsidiaries,
it nevertheless discourages repatriations. The negative effect of the current
system
on
repatriations is the major economic rationale cited by the Ways and Means
Committee’s press
release
proposing a territorial tax.23 This
argument also ties the lower repatriation rates to less
investment
and fewer jobs in the United States.
Before
discussing the potential effects, however, note that the repatriation argument
alone is not a
sufficient
justification for a territorial tax. The tax effect on repatriation could be
eliminated by
moving
in the opposite direction, ending deferral. Or it could be achieved by a
variety of hybrid
approaches
such as taxing a fixed share of profits currently and exempting the remainder,
or
allowing
an exemption combined with a minimum tax that is smaller than the U.S. tax
rate. All of
these
approaches create a system where taxation is not triggered by repatriation.
Would
the elimination of the tax triggered by repatriations (which could be achieved
by either a
territorial
tax or elimination of deferral) increase repatriations significantly? And if
so, would
those
increased repatriations result in more investment and jobs in the United
States?
Although
the projections vary with data source and with shares of pre-tax and after-tax
income,
estimates
in the previous section suggest that about a third of foreign subsidiaries’
earnings was
repatriated,
with discretionary distributions net of Subpart F income around 23%. Does that
imply
that
the remaining two thirds of income (or 77% of income net of Subpart F
distributions) would
be
repatriated? It is unlikely that much of an increase would occur, as discussed
below, and even
more
unlikely that it those repatriations would be translated into investment.
Several
considerations suggest that the increase in repatriations would be limited.
First, regardless
of
tax considerations, much of foreign source earnings would be retained abroad to
be reinvested
in
the enterprises there. Historical evidence on corporate rates of return and
growth rates in the
United
States suggest that about 60% of nominal income is typically retained to
maintain the real
capital
stock and allow it to grow normally at a steady state.24 The remainder, 40%, would be
distributed.
Thus we might expect, using the estimates above, at best to see an increase of
7% of
earnings,
or 17% of earnings net of Subpart F income.
Second,
these repatriation rates are probably at an unusually low level because they
followed the
large
one time repatriation (generally in 2005) from the temporary repatriation
holiday enacted in
2004.
Not only had large sums been repatriated to take advantage of a one time tax
exemption
which
reduced the need for repatriations immediately after the holiday, but more
might have been
retained
abroad than usual in anticipation of another holiday.25 Historical data indicate that
23Camp Releases International Tax Reform
Discussion Draft , October 26, 2011, at http://waysandmeans.house.gov/
News/DocumentSingle.aspx?DocumentID=266168.
24 If the rate of return were 10%, the steady
state nominal growth rate were 6% (a typical value reflecting a real growth
rate of 3% and an inflation rate of 3%), then the remainder
would be paid out as a 4% dividend yield. These are typical
historical values in the United States. Thus, in a steady state
growth model with these values, 60% of nominal earnings
would be retained in any case (and would be retained if taxes
did matter), and 40% paid out.
25 See CRS Report R40178, Tax Cuts on Repatriation Earnings
as Economic Stimulus: An Economic Analysis,
by
Donald J. Marples and Jane G. Gravelle. Another repatriation
holiday was voted on in the Senate in 2009, but not
adopted.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 14
repatriation
rates fell towards the end of the 1990s and continued to be low from 2000 to
2008.26
Data
were provided every other year and did not include 2005, the year most
repatriations
occurred
under the repatriation holiday. Over the period 1968-2008, the average
repatriation rate
was
40%; for 2000-2008 it was 20%. In addition to the anticipation and aftermath of
repatriation
holidays,
the growth of high-tech and dot.com firms that were expanding rapidly and not initially
paying
dividends may also have affected these payout ratios.27 The evidence from tax data is also
consistent
with studies examining repatriation rates over an earlier period of time using
financial
data
that found rates of around 40%.28 Since
a 40% rate is about the rate that might be expected in
a
no-tax world, these results suggest that the repatriation tax has had
relatively little effect on a
permanent
basis. If firms came to believe another repatriation holiday or territorial tax
were not in
store,
and the high-tech industries achieved a steady state growth, repatriation rates
might rise to
more
normal levels.
Third,
there is direct evidence that shifting to a territorial tax would not have
large effects. Some
initial
evidence indicates that the Japanese shift to a territorial tax increased
repatriations in the
first
year by about 20%.29 Applied to current realizations rates, it
would increase realizations by
about
4% of total earnings; compared to the 40% rate it would increase realizations
by about 8%
of
earnings. Since a larger first year effect might be expected, as pent up
earnings are returned,
such
an increase is quite modest. Preliminary results from a study of the UK
territorial tax shift,
while
subject to revision, suggest an increase of 6% of earnings.30 A statistical study of U.S.
affiliates
in different countries facing different taxes suggested that repatriations
would increase
by
about 13%, which would be 2.5% to 5% of earnings.31
Moreover,
some theory and research suggests the effects would be negligible on a
permanent
basis.
Theoretical considerations indicate that the repatriation tax should not matter
because firms
will
eventually have to repatriate earnings. This theory, referred to as the “new
view” is related to
a
similar theory about why domestic firms pay dividends to their individual
shareholders even
though
it triggers a dividend tax. In both cases, the idea is that eventually
shareholders will want
to
receive their dividends in excess of amounts needed for steady state
reinvestment and
dividends
will be paid either currently, or in the future with interest. In either case,
the same
present
value of tax will occur. While this “new view” for dividends paid in the U.S.
to its
individual
shareholders could be rejected on the grounds that firms can return cash to the
26 Data from 1992 to 2008 were from Internal
Revenue Service Statistics of Income, Data on Controlled Foreign
Corporations,
http://www.irs.gov/taxstats/bustaxstats/article/0,,id=97151,00.html. Data from
1968-1992 reported in
James R. Hines, Jr., The Case Against Deferral: A Deferential
Consideration, National Tax Journal ,Vol. 52,
September 1999, pp. 385-404.
27 The evidence does not support the idea that
the fall in repatriations was due to check-the-box, which was first
announced at the beginning of 1997. Subpart F income did not
begin to decline as a share of income until 2004.
28 Mehir A. Desai, C. Fritz Foley, and James
R. Hines, Jr., Dividend Policy Inside the Multinational Firm, Financial
Management, March 22, 2007, at
http://www.thefreelibrary.com/Dividend+policy+inside+the+multinational+firm.-
a0167305683.
29 Testimony of Mr. Gary M. Thomas Before the
Committee on Ways & Means, U.S. House of Representatives,
Hearing on How Other Countries Have Used Tax Reform To Help
Their Companies Compete in the Global Market and
Create Jobs, May 24, 2011, at
http://www.whitecase.com/files/Uploads/Documents/GThomas-HWM-Testimony-
24May2011.pdf.
30 Peter Egger, Valeria Merlo, Martin Ruf, and
Georg Wamser, The Consequences of the new UK
Tax Exemption
System: Evidence from Micro-level
Data, Working Paper, January 26, 2012.
31 Mehir A. Desai, C. Fritz Foley, and James
R. Hines, Jr., “Repatriation Taxes and Dividend Distortions,” National
Tax Journal, Vol. 54, December 2001, pp. 829-851.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 15
economy
by repurchasing shares, such an option is not available for dividend payments
between a
multinational
affiliate and its parent.
If
the theory correctly describes behavior, then one would expect that, regardless
of the
repatriation
tax a similar share of earnings would be paid in dividends with or without a
repatriation
tax. A large empirical literature has developed to study repatriation behavior,
finding
a
variety of results. For example, some early evidence suggested that
repatriation rates are
sensitive
to tax, but subsequent research showed that it might be due to transitory
effects.32
Evidence
that repatriations were more likely from highly taxed subsidiaries (where taxes
generated
would be offset by foreign tax credits) relative to low taxed ones suggested
that taxes
have
effects on repatriations.33 However, another study found that the
repatriations tax became
less
important given alternative strategies for returning cash for the United
States.34 These
strategies
included making passive investments abroad with the parent company borrowing
against
them, or having low tax subsidiaries make equity investments in high tax
subsidiaries
which
in turn repatriated income with attached foreign tax credits.35 These strategies would
indicate
differential repatriation rates exist between high and low tax subsidiaries but
they are not
necessarily
meaningful. Most recently, a study suggested taxes had some effect, but a
limited one,
on
repatriations; this study also showed over a long period of time payout shares
of about 40%.36
The
recent pressure for a repatriation holiday and reports of large amounts of
accumulated
unrepatriated
earnings probably comes largely from firms that have intangible assets, have
been
growing
rapidly abroad and thus retaining earnings for that purpose, and perhaps
shifting profits
arbitrarily.37 They may have also been delaying
repatriations in anticipation of another holiday. As
affairs
settle into more of a steady state, there may be a greater need to distribute
to pay
shareholders,
so this phenomenon may be largely transitory.
Even
if repatriations increase under a permanent territorial tax, those
repatriations may not result
in
additional investment, but are likely to be paid out as dividends, or
substitute for borrowing by
the
parent company.38 Job creation is not the primary focus here
in any case, as in the long run,
32 See Rosanne Altshuler, T. Scott Newlon, and
William C. Randolph, “Do Repatriations Matter? Evidence from Tax
Returns of Multinationals,” in The Effects of Taxation on Multinational Corporations, Ed. by Martin Feldstein, James r.
HInes, Jr. and R. Glenn Hubbard, Chicago: University of Chicago
Press, 1995, pp. 253-277.
33 Mehir A. Desai, C. Fritz Foley, and James
R. Hines, Jr., “Repatriation Taxes and Dividend Distortions,” National
Tax Journal, Vol. 54, December 2001, pp. 829-851.
34 Rosanne Altshuler and Harry Grubert,
“Repatriation Taxes, Repatriation Strategies and Multinational Financial
Policy, Journal of Public Economics, Vol 87, 2002, pp. 73-107.
35 Some methods of returning cash to the
United States involve corporate reorganizations. See Jesse Drucker, “Dodging
Repatriation Tax Lets Companies Bring Home Cash,” Bloomberg,
December 29, 2010, http://www.bloomberg.com/
news/2010-12-29/dodging-repatriation-tax-lets-u-s-companies-bring-home-cash.html.
For an in depth discussion of
methods, see Hal Hicks and David J. Sotos, “The Empire Strikes
Back (Again) – The Killer Bs, Deadly Ds and Sec.
367 As The Death Star Against Repatriation Rebels,”. International Tax Journal, May-June 2008, pp. 37-58. The
Internal Revenue Service has periodically attempted to address
various methods of repatriating cash without paying tax,
most recently in July 2012. See Richard Rubin, “IRS Ends Deals
That Let Companies Avoid Repatriation Tax,”
Bloomberg, July 13, 2011, at
http://www.bloomberg.com/news/2012-07-13/irs-ends-deals-that-let-companies-avoidrepatriation-
tax.html.
36 Mehir A. Desai, C. Fritz Foley, and James
R. Hines, Jr., Dividend Policy Inside the Multinational Firm, Financial
Management, March 22, 2007, at
http://www.thefreelibrary.com/Dividend+policy+inside+the+multinational+firm.-
a0167305683.
37 CRS Report R40178, Tax Cuts on Repatriation Earnings
as Economic Stimulus: An Economic Analysis,
by Donald J.
Marples and Jane G. Gravelle.
38 The repatriations under the repatriation
holiday, enacted on the basis of increasing investment, were largely used to
(continued...)
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 16
reduce
jobs. The economy will tend to create jobs naturally. As an illustration,
consider that in
1961
and in 1991 the unemployment rate was the same, 6.7%. Employment, however, rose
from
66
million to 117 million, as the economy accommodated the baby boom and the entry
of women
into
the labor force. Permanent provisions that encourage capital to move abroad can
change the
types
of jobs and reduce wages, but not overall employment.39
Location of Investment
Historically,
the central issue in evaluating a foreign tax regime has been the effect on the
allocation
of investment. Economic theory seeking efficiency objectives supports taxing
investments
at the same rate wherever they are invested; this approach would maximize
worldwide
output by investing capital where it earns the highest pre-tax return. For
example, if
the
after tax return is 7% and the U.S. tax is an effective 30% while the foreign
tax rate is zero,
and
investments are perfect substitutes, the total pre-tax return at the margin on
an investment in
the
United States is 10% (0.07/(1-0.30) while the return in the foreign location is
only 7%.
Allowing
foreign source income to be exempt causes capital to move to a less productive
use,
where
it earns a pre-tax return of 7%, when it could earn a 10% return in the United
States.40
The
equating of taxes on a firm’s investment is most closely associated with a
residence based tax
system.
Given the need for limits on foreign tax credits, this system would be most
closely
approximated
by a system that eliminates deferral and imposes a foreign tax credit limit on
a
country
by country basis. If the objective were not worldwide optimization or
efficiency, but
maximizing
U.S. welfare, the rules would be more stringent by allowing foreign taxes as a
deduction
rather than a credit.41
Assessing Arguments for A
Territorial Tax
What,
then, is the justification for moving in the opposite direction, to a
territorial tax? One may
be
that if, for political or other reasons, it is not possible to move closer to a
residence-based
system,
it is possible to design a territorial tax system that is an improvement over
the current
rules.
This argument is made by Grubert and Mutti,42
and their proposal was incorporated in
President
Bush’s Advisory Commission’s tax reform proposals.43 Grubert and Mutti proposed,
along
with exempting active dividends from tax, to provide for an allocation of
overhead costs of
(...continued)
repurchase shares, the equivalent of paying dividends. See CRS
Report R40178, Tax Cuts on Repatriation Earnings
as
Economic Stimulus: An Economic
Analysis, by Donald J. Marples and Jane G.
Gravelle, for a review of the evidence.
39 Using repatriations to increase employment
in an underemployed economy in the short run are unlikely to be
effective because transferring foreign earnings into U.S.
dollars is contractionary and likely overwhelms any direct
spending effects. See CRS Report R40178, Tax Cuts on Repatriation Earnings
as Economic Stimulus: An Economic
Analysis, by Donald J. Marples and Jane G. Gravelle.
40 Note that economic analysis has focused on
efficient allocation of investment, rather than the effects on jobs because
in the long run (the focus of a permanent tax law), an economy
will tend to naturally create jobs.
41 The issues discussed in this section are discussed
in more detail in CRS Report RL34115, Reform
of U.S.
International Taxation:
Alternatives, by Jane G. Gravelle.
42 Harry Grubert and John Mutti, Taxing International Business Income:
Dividend Exemption Versus the Current
System,” Washington, DC, The AEI Press, 2001.
43 The President’s Advisory Panel on Federal
Tax Reform, Simple, Fair and Pro-Growth:
Proposals to Fix America’s
Tax System, November, 2005, at
http://govinfo.library.unt.edu/taxreformpanel/.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 17
the
firm (such as interest) between taxable and tax exempt income. For example, if
10% of
income
is exempt because of the dividend exemption then 10% of interest and other
overhead
costs
would be disallowed. They also note that that the elimination of foreign tax
credits would
mean
that royalty, export and other income would not be shielded from U.S. tax with
excess
foreign
tax credits. As a result, this proposal is projected to raise revenue, a result
also found by
the
Joint Committee on Taxation, and the overall tax rate on foreign source income
would rise.44
Grubert
and Mutti also note that repatriations would not trigger a tax and that such a
change
would
reduce the cost of tax planning to avoid the repatriation tax.
The
argument that a territorial tax that could improve economic efficiency, or at
least make it no
worse,
should be distinguished from arguments that do not stand up to economic
reasoning. For
example,
moving to a territorial system because other countries have generally done so
does not
mean
such a system is desirable either for them or for the United States. Many
policies exist in
other
countries, such as a value added tax or national health insurance, policies
that many oppose
and
that have not been adopted in the United States. The issues may differ as well.
European
countries,
for example, are geographically and politically closer than the United States
is to other
countries.
The European Union also has provisions on freedom of capital movement and
establishment
that prevent the type of anti-inversion laws that the United States has, to
prevent
U.S.
firms from relocating their headquarters.45
These rules may influence decisions to adopt
territorial
systems as well as decisions to lower corporate tax rates, which has occurred
in the
United
Kingdom recently.
Similarly,
the argument that because most other countries do not tax their foreign
subsidiaries, the
United
States also should not do so in order to allow its firms to compete abroad does
not stand
up
to economic analysis. A country does not compete in the manner that a firm
does, because its
resources
(labor and savings provided by its citizens) do not disappear if another firm
undercuts
prices;
they are simply used in a different way. That is, a country does not compete
with the rest
of
the world, it trades with them, both its products and its capital. It can
generally be shown that
the
United States would still be better off, or at least no worse off, if it taxes
foreign and domestic
investments
by its firms at the same rate, even if other countries do not.46
Finally,
arguments made based on empirical studies that indicate that increased foreign
investment
of multinationals is correlated with more, not less, domestic investment do not
show
that
overall U.S investment is not reduced by more favorable foreign treatment, and
may simply
identify
firms that are growing. In any event, the aggregate amount of capital owned by
U.S.
citizens
and the allocation of that capital are separate issues. Even if savings
responds to the
overall
U.S. tax burden, of two revenue neutral regimes, the one that taxes capital
equally in both
locations
would be more efficient.
44 The proposal is estimated to raise revenues
by $6.9 billion in FY2014. See Congressional Budget Office, Reducing
the Deficit: Spending and Revenue
Options, March, 2011, p. 187,
http://www.cbo.gov/sites/default/files/cbofiles/
ftpdocs/120xx/doc12085/03-10-reducingthedeficit.pdf.
45 Countries can adopt anti-abuse provisions
that are more limited. See Marco Rossi, “European Commission Blesses
Italy’s Anti-Inversion Rules,” at
http://www.euitalianinternationaltax.com/2011/05/articles/european-commissionblesses-
italys-antiinversion-rules/.
46 See Jane G. Gravelle, Does the Concept of
Competitiveness Have Meaning in Formulating Corporate Tax Policy?
November 2011, forthcoming, Tax Law Review, at
http://www.americantaxpolicyinstitute.org/pdf/
Jane%20Gravelle%20paper.pdf. Critiques of competitiveness
arguments were also made, primarily with respect to
trade policy, by Paul Krugman, See “Competitiveness: A Dangerous
Obsession,” Foreign Affairs, Vol. 73, No. 2
(March-April, 1994), pp. 28-44. Links to the journal can be
found at http://www.foreignaffairs.com/issues/1994/73/4.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 18
There
are some arguments that have been made that bear consideration. Perhaps the
most
important
of these is that U.S. firms can change their nationality by moving their
headquarters
abroad,
merging with foreign companies, or incorporating abroad. However,
anti-inversion rules
adopted
in 2004 are likely to prevent large-scale shifting of headquarters of existing
firms, while
mergers
and incorporating abroad are probably largely determined by non-tax factors and
could
be
addressed with legislative revisions.47
Evidence suggests that very little incorporation of true
U.S.
firms occurs abroad48 and this effect could be addressed with
legislation (such as basing
taxation
on where effective management occurs) if necessary.
Arguments
have also been made that the higher taxes on returns to capital investments
would
prevent
U.S. firms from exploiting intangible assets abroad.49 However, there are many ways of
exploiting
intangibles without engaging directly in manufacturing or other activities,
such as
licenses,
franchises, and contract manufacturing.50
Products embodying U.S. innovations could
also
be produced in the United States and exported.
Likely Effects of International
Tax Revision on Investment
What
are the likely effects of altering the international tax system on investment?
There are
several
reasons that these effects would probably be modest, although they would depend
on the
particular
design features of the reform.
First,
most countries where physical investment might take place, such as
manufacturing, tend to
have
taxes that are not much different from those that apply in the United States:
average
effective
rates of 27% and marginal effective rates of about 20%.51 The average effective tax rate
on
foreign subsidiaries of U.S. parents is estimated to be lower than that of U.S.
firms in general
(about
16% versus 26% with a 3% residual U.S. tax on foreign earnings), but that partially
reflects
profit shifting to low tax countries, since the effective rate in tax haven
countries was
5.7%.52 Overall effective tax rates abroad for
foreign subsidiaries of U.S. companies also vary by
47 Mergers that involve shifting the location
of incorporation do occur occasionally. The announced merger of Eaton
Corporation and Cooper Industries is an example of how mergers
can be used to shift headquarters although even in
this case the stated primary reason was non-tax issues. Cooper
was already incorporated in Ireland, but is effectively a
U.S. company with management in Houston. See Robert
Schoenberger, “Eaton Corporation Plans to Buy Cooper
Industries, Move Incorporation to Ireland,” The Plain Dealer, May 12, 2012. http://www.cleveland.com/business/
index.ssf/2012/05/eaton_corp_plans_to_merge_with.html. Aon’s
shift of incorporation to the U.K. will trigger a
shareholder level capital gains tax. See “Aon Shareholders May
Pay Hefty Taxes With Headquarters Shifting to
London,” Ameet Sachdev’s Chicago Law, at
http://articles.chicagotribune.com/2012-01-20/business/ct-biz-0120-
chicago-law-20120120_1_aon-global-aon-corp-tax. Among solutions
to limit tax motivated international mergers is
imposing a tax on shareholder gain at ordinary rates.
48 Susan Morse and Eric Allen, “Firm
Incorporation Outside the U.S.: No Exodus Yet,” December 2011, at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1950760.
49 This idea is most recently addressed in
Mihir Desai and James Hines, “Evaluating International Tax Reform,”
National Tax Journal, Vol. 56, September 2003, pp. 487-502.
50 See CRS Report RL34115, Reform of U.S. International
Taxation: Alternatives, by Jane G. Gravelle, for a more
detailed discussion of this issue.
51 See CRS Report R41743, International Corporate Tax Rate
Comparisons and Policy Implications,
by Jane G.
Gravelle.
52 Melissa Costa and Jennifer Gravelle, Taxing
Multinational Corporations: Average Tax Rates, Presented at a
Conference of the American Tax Policy Center, October 2011, and forthcoming
in Tax Law Review, at
http://www.americantaxpolicyinstitute.org/pdf/Costa-Gravelle%20paper.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 19
industry.
Industries with a lot of intangible assets have lower tax rates. For example,
computer
and
electronic product manufacturing had an effective tax rate of 8.7% and finance
11.3%.53
Second,
to the extent that firms expect largely to avoid U.S. taxes under the current
system, either
through
permanent reinvestment of profits or tax planning, moving to a territorial tax
would not
make
much difference in inducing outflows of capital, especially if anti-base
erosion provisions
(such
as treating income earned in tax haven countries as Subpart F Income) are
adopted.
Nevertheless,
since firms’ investments are only observed under the current deferral and
foreign
tax
credit system, it is possible that significantly more capital would be invested
abroad,
especially
in lower tax jurisdictions.
Moving
in the opposite direction, by ending deferral and possibly cross-crediting
(with a per
country
foreign tax credit limit) would reduce capital investment abroad by retaining
more
outbound
capital in the United States.
Nevertheless,
effects from either revision are unlikely to be important to the overall U.S.
economy
or to U.S. welfare; estimates of the effect of cutting the U.S. corporate tax
rate by ten
percentage
points, which would presumably have larger effects by attracting inbound
capital as
well
is estimated to increase U.S. output by only about 2/10ths of 1% and U.S. income by 2/100ths
of
1%.54 The effects of moving to a territorial tax
would be negative (decrease U.S. output)
because
they increase the return on outbound capital, but would be smaller in magnitude
because
the
effects are smaller. Based on relative sizes of revenue effects, a ten
percentage point rate
reduction
would lose about 29% of corporate revenue, while, based on the estimates in Table
5,
eliminating
all taxes on foreign source income would lose about 7.5% of corporate revenue,
or a
quarter
of the amount. Eliminating deferral alone would gain revenue equal to about 15%
of the
absolute
change from a ten percentage point rate reduction, while eliminating deferral
and crosscrediting
would
be about 53% of the change. This last change could be more significant than the
domestic
rate reduction but nevertheless not large relative to the U.S. economy.
All
of these effects are small, relative to output, for several reasons. First, although
capital flows
respond
to differential tax rates, capital is not perfectly mobile.55 Even if it were, the large size of
the
U.S. domestic economy and capital stock and the constraints of production
(capital must
combine
with labor to be productive) limit the effect to ½ of 1% of output and a
negligible effect
53 Charles Duhigg and David Kocieniewski, “How
Apples Sidesteps Billions in Taxes,” New
York Times, April 29,
2012, p.1, 20-21. at
http://www.nytimes.com/2012/04/29/business/apples-tax-strategy-aims-at-low-tax-states-andnations.
html?pagewanted=all.
54 See CRS Report R41743, International Corporate Tax Rate
Comparisons and Policy Implications,
by Jane G.
Gravelle.
55 The overall evidence suggests an elasticity
of around three which is used in the calculations above; see Jennifer C.
Gravelle, Corporate Tax Incidence: Review of General Equilibrium
Estimates and Analysis, Working Paper 2010-03,
May 2010, at
http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/115xx/doc11519/05-2010-working_papercorp_
tax_incidence-review_of_gen_eq_estimates.pdf. See Harry Grubert
and Rosanne Altshuler, “Corporate Taxes in
the World Economy: Reforming the Taxation of Cross-border
Income,” in Fundamental Tax Reform: Issues,
Choices,
and Implications, Ed. John W. Diamond and George R. Zodrow, Cambridge, MIT
Press, 2008 who reference a number
of studies showing that investment by multinationals is
sensitive to tax rates. A review is also contained in Michael
Smart , Repatriation Taxes and Foreign Direct Investment: Evidence
From Tax Treaties, Working Paper, June 20,
2010, at
http://www.sbs.ox.ac.uk/centres/tax/symposia/Documents/2010/05%20Smart.pdf; and
in Lars Feld and Jost
Heckemeyer, “FDI and Taxation: A Meta Study,” Journal of Economic Surveys, Vol 25, April, 2011, pp.233-272 . The
working paper version is at
http://www.cesifo-group.de/portal/pls/portal/docs/1/1186528.PDF.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 20
on
income.56 The corporate tax itself is also small as a
cost factor: about 2% of GDP. Thus even a
10
percentage point rate reduction would be slightly over ½ of 1% of GDP, while
most
international
revisions would be even smaller. Finally, most of these gains would not accrue
to
U.S.
income: for inbound capital most of the gain would be profit to foreign
investors, and for
outbound
capital drawn back, profits were already in existence and merely change
location.
The
analysis in this section suggests that while there may be concerns about the
effects of
international
reforms on investments, either reducing U.S. investment in the case of a
territorial
tax
or increasing it by moving towards a residence based tax (e.g., eliminating
deferral and crosscrediting)
these
effects are likely quite modest.
Treatment of Royalties and
Export Income
One
effect of the current system that might be changed by moving to a territorial
system is the
reduction
in the beneficial treatment of royalties and export income through the use of
excess
foreign
tax credits. The current benefits for royalties encourage firms to exploit
intangibles in
foreign
operations rather than in the United States, while the export subsidy causes
prices and
magnitudes
of exports to be too large.
Royalties,
in particular, are a difficult issue to address because increased taxes on
royalties paid
from
foreign subsidiaries would encourage manufacturing of goods in the United
States but, as
will
be discussed in the next section, also creates an incentive to understate royalties
and
artificially
shift intangible income into untaxed active earnings of foreign subsidiaries
that are
exempt.
Ideally, such profit shifting should be addressed by anti-abuse provisions.
Artificial Profit Shifting
The
third issue, which primarily involves revenue, is artificial profit
shifting—that is, shifting
profits
into low-tax jurisdictions that are then exempt from U.S. tax. Profit shifting
also exists
under
the current system because of deferral. Evidence of profit shifting is clear
from the
distribution
of shares of U.S. subsidiary profits as a percentage of GDP, where profits as a
percentage
of output were typically less than 1%-2% in the G-7, were significantly larger
in the
larger
tax-haven countries (7.6% in Ireland and 18.2% in Luxemburg), and were more
than 600%
and
500% respectively in Bermuda and the Cayman Islands.57 The estimates of magnitude vary
substantially
reaching up to $90 billion and ranging from about 14% to 29% of corporate
revenues.58 They have been growing as well.59
56 Estimates from CRS Report R41743, International Corporate Tax Rate
Comparisons and Policy Implications,
by
Jane G. Gravelle, based on perfect mobility of capital and
perfect product substitution.
57 CRS Report R40623, Tax Havens: International Tax
Avoidance and Evasion and CRS Report R41743, International
Corporate Tax Rate Comparisons
and Policy Implications, both by Jane
G. Gravelle. Data on earnings and profits of
controlled foreign corporations were taken from Lee Mahoney and
Randy Miller, Controlled Foreign Corporations
2004, Internal Revenue Service Statistics of Income Bulletin,
Summer 2008,http://www.irs.ustreas.gov/pub/irs-soi/
04coconfor.pdf. Data on GDP from Central Intelligence Agency,
The World Factbook, https://www.cia.gov/library/
publications/the-world-factbook. Most GDP data are for 2008 and
based on the exchange rate but for some countries
earlier years and data based on purchasing power parity were the
only data available.
58 See CRS Report R40623, Tax Havens: International Tax
Avoidance and Evasion and CRS Report R41743,
International Corporate Tax Rate
Comparisons and Policy Implications,
both by Jane G. Gravelle. For the most recent
estimates see Kimberly A. Clausing “The Revenue Effects of
Multinational Firm Income Shifting Tax
Notes, March
(continued...)
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 21
In
general, most of this profit shifting apparently arises from either leveraging
(borrowing in
high-tax
jurisdictions) or shifting of the location of profits from intangibles. It is
not surprising,
therefore,
that low-tax rates tend to be associated with manufacture of drugs and
electronics, and
the
information and communications industries.
Profit
shifting is a policy problem even without a move to a territorial tax. One of
the concerns
about
moving to a territorial tax is the possibility that it will increase the
already significant and
growing
estimated level of profit shifting. Under current law, firms that have shifted
profits to
low-tax
jurisdictions may still have to face eventual taxation. The considerable
lobbying for a
repatriation
holiday such as that in 2004 may be a sign of this concern.60 With a simple territorial
tax
with no anti-abuse provisions, profit shifting could increase substantially.
There is little to
clarify
the likely magnitude of this effect. Evidence for European countries has also
indicated
significant
profit shifting, benefiting most European countries largely at the expense of
Germany.61 Germany has since lowered their corporate
tax rate (and profit shifting may have
played
a role in that decision). However, it is difficult to draw conclusions from the
experiences
of
these very different countries, who already have territorial systems but also
have in most cases
had
measures to address base erosion.
If
the new view of dividends is correct, and companies expect to pay taxes on
excess profits with
interest
when deferred, then the move to a simple territorial tax (without any anti-base
erosion
measures)
could increase profit shifting, perhaps considerably. However, if this view is
not
correct
and firms expect to escape tax indefinitely, then going to a territorial tax
might not make
much
difference. Unfortunately, while there is a relatively powerful theoretical
justification for
the
new view, the empirical evidence has been mixed. At the same time, however, as
noted above,
the
lobbying for a repatriation holiday supports the new view and the expectation
that profit
shifting
might increase insignificantly.
One
particular potential effect on profit shifting involves royalties. Because
royalties are
protected
to some extent by excess foreign tax credits, moving to a territorial tax would
eliminate
that
protection and increase the tax on royalties. This change in taxation would
create a further
incentive
to shift intangible income into the earnings of foreign subsidiaries and out of
royalties.
Aside
from the issue of the effect of a territorial tax (and of its particular design
features) on
profit
shifting, other reforms might be considered that might address profit shifting
either in the
current
system or in a system revised in ways other than moving to a territorial tax.
These reforms
might
include provisions reforming the current system proposed by President Obama
(and earlier
by
former Ways and Means Committee Chairman Rangel), which would tax excess
earnings from
(...continued)
28, 2011, pp. 1580-1586, who finds estimates for 2008 from $57
billion to $90 billion and Martin Sullivan, “Transfer
Pricing Costs U.S. at Least $28 Billion,” Tax Notes, March 22, 2010, pp. 1439-1443.
59 Martin Sullivan, “Transfer Pricing Abuse Is
Job-Killing Corporate Welfare,” Tax
Notes August 2, 2010, pp. 461-468.
60 The lobbying group has apparently ended at
least part of their campaign. See “WIN America, Tax Repatriation
Holiday Lobby Group, Ends Advocacy Work” Reuters,
http://www.huffingtonpost.com/2012/04/23/win-america-taxrepatriation-
holiday_n_1447581.html?ref=business. For a report on the
repatriation holiday and its issues see CRS
Report R40178, Tax
Cuts on Repatriation Earnings as Economic Stimulus: An Economic Analysis, by Donald J.
Marples and Jane G. Gravelle.
61 Harry Huizinga and Luc Laeven,
“International Profit Shifting Within Multinationals: A Multi-Country
Perspective,”
Journal of Public Economics, vol. 92. 2008, pp.1164-1182.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 22
intangibles
as subpart F income and rules that would disallow some portion of overhead
expenses
to
the extent income is not taxed.
Fundamentally,
as long as a system allows for differential taxes, whether between the U.S. and
foreign
source income or between types of foreign source income, there is likely to be
profit
shifting.
Companies appear willing to exploit relatively small differentials in tax as
illustrated by
the
double-Irish, Dutch sandwich technique that allowed firms to not only avoid the
U.S. tax, but
to
avoid the 12.5% Irish tax as well, and establish taxation in Bermuda, with a
zero tax rate.62 The
only
tax system that eliminates differential taxes is the elimination of deferral,
possibly combined
with
a separate tax credit limit basket for royalty income.
Transition
An
important issue in moving to a territorial tax is how to treat accumulated
unrepatriated
earnings,
which were generated under a worldwide system. One approach would be to deem
all
accumulated
earnings as repatriated and pay taxes, with a number of years allowed to pay
these
taxes.
The provision might create a hardship for firms to the extent that income is
tied up in nonliquid
form,
unless the period of time for paying the tax were extensive. In addition, it
would be a
retroactively
harsh tax compared with the present system, because a significant portion of
earnings
need never be repatriated. During normal times, estimates suggest that more
than half of
retained
earnings abroad is probably reinvested in the firms activities. Note also that
while
perhaps
60% or so of the flow of income would be retained abroad, a much larger share
of the
stock
of unrepatriated earnings would be likely to be permanently reinvested abroad.
Another
option is to treat these earnings the same as newly generated earnings and
exempt them
in
the same way. This approach would create a windfall benefit, especially to the
degree that
firms
have been holding off repatriating and engaging in aggressive profit shifting
because of a
potential
tax holiday.
A
third option would be to treat dividends as paid out of accumulated earnings
until these
earnings
are exhausted, while applying the full tax rate and foreign tax credit rules.
This
approach,
however, would continue the disincentive to repatriate for some time.
None
of these approaches may be entirely satisfactory. Intermediate proposals that
are under
consideration
would tax this income but at a lower rate. One, in the Ways and Means proposal,
is
to
deem all this earnings repatriated prior to the law changes, apply the
provisions of the 2004 tax
holiday
(85% exclusion of income with proportional foreign tax credits), which would
impose a
small
tax, and allow it to be paid over a period of time. On average this may be a
reasonable
compromise,
because, although a significant fraction of income is exempt, a significant
fraction
of
this income would probably never have been repatriated.
A
second intermediate option is to allow firms to elect the holiday (with an
extended pay out
period)
and to tax any remaining dividends at the full tax rate until all of the
remaining earnings is
paid
out as dividends. This voluntary approach allows firms to avoid undesirable
forced payouts,
but
prolongs the effective movement to a territorial tax.
62 Jesse Drucker, “Google 2.4% Rate Shows How
$60 Billion Lost to Tax Loopholes,” Bloomberg, October 21, 2010,
at
http://www.bloomberg.com/news/2010-10-21/google-2-4-rate-shows-how-60-billion-u-s-revenue-lost-to-taxloopholes.
html.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 23
Striking
a balance between limiting the windfall benefits and the associated revenue
loss
compared
with a baseline, providing firms with terms that allow the funds to pay (since
a lot of
accumulated
earnings are not liquid) and avoiding prolonged coverage of dividends under the
old
system
is one of the most difficult problems in crafting a shift to a territorial tax.
As will be
discussed
subsequently, the proposals have included a variety of approaches.
While
accumulated untaxed earnings are an important issue, there are other transition
issues
relating
to the shift from the current system to a territorial tax. These include unused
foreign tax
credits
associated with previously taxed income and foreign loss carryovers. How
credits and
losses
might be treated may depend largely on the treatment of existing earnings
accumulated
abroad
and how other features of the foreign tax credit are modified.
Administration and Compliance
Arguments
have often been made that moving to a territorial tax would simplify
administration
and
compliance. Grubert and Mutti, in their proposal for a territorial tax,
stressed the cost of tax
planning
associated with repatriating income while paying minimal tax. Thus a
territorial tax
would
add value by simplifying repatriation policy. U.S. parents could receive
dividends from
their
subsidiaries without concerns about the tax consequences. However, the same
simplification
would
occur if deferral were ended, because firms would have no choice about paying
taxes or
arranging
for optimal cross-crediting. Hybrid approaches such as taxing a share of income
currently
would also eliminate the scope for tax planning around repatriation.
Although
repatriation tax planning would be eliminated, if a territorial tax increased
profit
shifting
incentives, tax planning in that area could increase. And, as will be shown in
the
discussion
of design issues, provisions considered to combat income shifting can add
considerable
complexity to the tax code.
Revenue Issues
A
shift to a territorial system could potentially gain revenue, in part because
relatively little tax is
collected
on foreign operations. In any case, it is unlikely that large revenue losses
would occur
unless
the move to a territorial tax includes other provisions (such as lower tax
rates on royalties)
or
induces pronounced income shifting responses. If Table
4 shares of income are applied to
estimates
of current taxes paid on foreign source income listed in Table
5, the taxation of
dividends
of foreign subsidiaries is quite small, a little over $4 billion in FY2014, or
about 1% of
corporate
revenues. Branch income is slightly under $6 billion, so if this income is also
exempted
in
a move to a territorial tax, the total effect would be about $10 billion. The
two together are
about
2% of corporate revenues. Taxes on royalties and export income (which along
with
nonfinancial
interest would be somewhat over $10 billion, or about 2% of revenues) could
increase
with the loss of foreign tax credits, leading to a relatively small net loss or
possibly a
small
gain.
There
is considerably more revenue to be gained by moving in the opposite direction,
as some
proposals
do. Eliminating deferral and providing a per country foreign tax credit limit
could triple
the
revenue collected on foreign source income, raising $64 billion or about 15% of
corporate
taxes,
according to the estimates in Table 5.
Other intermediate changes could raise revenues;
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 24
eliminating
deferral alone would raise about $18 billion in revenue, and the combination of
President
Obama’s budget proposals for international taxation would raise $16 billion.63
Some
proposals for moving to a territorial tax aim for revenue neutrality, but also
propose to use
transitional
revenues (from taxes on accumulated untaxed earnings) to achieve this revenue
neutrality
in the budget horizon. Because transitional gains are temporary, this approach
results in
a
long-run revenue loss.
Design Issues in a Territorial
Tax
Moving
to a territorial tax goes far beyond a simple matter of exempting foreign
source income
from
U.S. tax. There are issues of transition, the treatment of current flow through
income, and
the
retention and perhaps revision of anti-abuse rules. In this section, three
proposals are outlined:
the
Grubert Mutti proposal, the discussion draft provided by Ways and Means
Committee
Chairman,
and Senator Enzi’s bill, S. 2091. The latter two proposals are similar in
general
approach.
Note that the Grubert Mutti proposal is a general outline, while the Ways and
Means
Discussion
Draft and S. 2091 are in legislative language and are more detailed.
The Grubert Mutti Proposal
This
proposal has been circulating for some time as a general proto-type of a move
to a territorial
tax,
and has been estimated to raise revenue, primarily due to increased taxes on royalties
and
allocation
of parent company expenses between taxable and exempt income.64 A proposal of this
nature
was included in President Bush’s Advisory Panel Proposal in 2005.65
• Exemption
of dividends for active foreign income by U.S. shareholders with a
10%
or more interest and eliminate foreign tax credits.
• Foreign
branches treated the same as subsidiaries.
• Royalties
and interest paid to the U.S. parent are taxable.
• Current
anti-abuse rules for passive income(Subpart F) would be retained,
although
some aspects would become obsolete (primarily the inclusion of
dividend
payments between subsidiaries).
• Parent’s
overhead expenses, such as interest, would be allocated in proportion to
untaxed
income and disallowed.
• Active
foreign losses could not offset domestic income.
• Capital
gains and losses from the sale of productive assets would be exempt.
• Income
from U.S. exports would not be classified as foreign source income.
63 Department of the Treasury, General Explanations of the
Administration’s Fiscal Year 2013 Revenue Proposals,
February 2012,
http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2013.pdf.
64 Harry Grubert and John Mutti, Taxing International Business Income:
Dividend Exemption Versus the Current
System (Washington, DC, AEI Press, 2001).
65 The President’s Advisory Panel on Federal
Tax Reform, Simple, Fair and Pro-Growth:
Proposals to Fix America’s
Tax System, November, 2005, at
http://govinfo.library.unt.edu/taxreformpanel/.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 25
The
proposal does not address the treatment of existing accumulated earnings abroad
or profit
shifting
via intangible assets, although one of the proposal’s authors has indicated that
their plan
should
probably include a tax on accumulated earnings, but at a lower rate.66
This
proposal has been estimated to raise revenue of approximately $6.9 billion in
2014.67 If the
shares
of revenue in Table 4 remain
the same for 2014, about 30% of current tax on foreign
source
income or slightly under $10 billion (based on aggregates from Table
5) is collected on
active
dividends and branch income. The additional taxes on royalties and export
income plus
limits
on the deduction of overhead expenses presumably raise about $17 billion
(replacing the
lost
revenue and generating additional amounts).
Ways and Means Chairman Camp’s
Discussion Draft
In
October 2011, Ways and Means Chairman Dave Camp released a discussion draft
outlining an
approach
to a territorial tax (hereafter Discussion Draft). This proposal includes some
options and
unsettled
issues, and there is not as yet a revenue estimate. Note also that the
intention expressed
in
press releases at that time was to couple the move to a territorial tax with a
general tax reform
that
would reduce the top corporate rate from 35% to 25%. This rate matters since
some
provisions
allow a proportional tax benefit. Since the other changes that might be needed
to
achieve
this reduction have not been yet spelled out, no observations on the effects if
any
remaining
revision will be included, outside of noting the consequences of the rate
change for
specific
territorial provisions.
The
following summary of these provisions does not include all of the detailed
nuances of the
proposal,
which are contained in a technical draft discussion.68
• Allows
a 95% deduction for the foreign source portion of dividends for 10% U.S.
corporate
shareholders of foreign subsidiaries that are controlled foreign
corporations
(CFCs). A holding period of one year for stock in foreign
corporations
is required. If the rate is reduced to 25%, dividends would be taxed
at
1.25%; at the current rate, they would be taxed at 1.75%. (CFCs are those
where
50% of the stock is owned by five or fewer 10% U.S. shareholders.)
• 10%
corporate shareholders of non controlled corporations (where 50% of the
stock
is not owned by five or fewer 10% U.S. shareholders, called 10/50
corporations)
can elect the same treatment as CFCs.
• Foreign
branches are treated the same as subsidiaries; the draft also considers the
possible
inclusion of partnerships in this treatment.
• Anti-abuse
(Subpart F) provisions are retained, although these rules would be
revised
in light of the other changes; these details are to be considered
subsequently.
Dividends paid between CFCs are exempt.
66 Author’s conversation with Harry Grubert,
July 2, 2012.
67 Congressional Budget Office, Reducing the Deficit: Spending
and Revenue Options, March 20, 2011, p. 187.
http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/120xx/doc12085/03-10-reducingthedeficit.pdf
68 Documents, including bill language,
technical discussions and shorter summaries can be found at the Ways and
Means Committee website at
http://waysandmeans.house.gov/taxreform/.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 26
• Capital
gains on sales of stock in active eligible subsidiaries are also eligible for a
95%
exclusion.
• Accumulated
untaxed earnings will be taxed with an 85% exclusion and
apportionment
of associated foreign tax credits in the same fashion as the 2004
repatriation
holiday, except that all earnings will be taxed rather than earnings
that
are voluntarily repatriated. No actual repatriation is necessary. Firms can pay
the
tax in installments with interest over eight years. Assuming this provision
applies
before changes in the statutory tax rate, the effective rate is 5.25% less
any
apportioned foreign tax credits.
• The
foreign tax credits associated with active dividends and with foreign branch
income
are disallowed (those for Subpart F are retained). All foreign tax credits
would
be in one basket, presumably because the active basket would no longer be
relevant.
The proposal also eliminates the allocation of parent interest that
presently
applies to determine the foreign tax credit limit: only directly
associated
expenses will be applied to determine foreign income. It would also
repeal
the provision preventing the splitting of foreign tax credits.
• A
provision that requires the inclusion in income of investments of deferred
income
(income that is not taxed because it is not distributed) in U.S. property is
repealed.
This provision exists to prevent firms from effectively repatriating
earnings
without declaring dividends that are subject to the tax.
• Three
anti-base-erosion options, two directed at intangible income, are
considered.
Option A is similar to a proposal made by President Obama in his
budget
proposals, that would tax excess earnings on intangibles (in excess of
150%
of costs) in low tax jurisdictions as Subpart F. The inclusion would be
phased
out between a 10% and a 15% rate. Option B would tax income that is
subject
to an effective foreign tax rate below 10% unless it qualifies for a home
country
exception. The home country exception applies when a firm conducts an
active
trade or business in the home country, has a fixed place of business, and
serves
the local market. Option C would tax all foreign income from intangibles
(whether
earnings by the foreign subsidiary or royalty payments) but allow a
deduction
for 40%, resulting in a tax rate of 15% at a 25% statutory tax rate.
• Additional
base-erosion provisions (sometimes call thin-capitalization rules)
relating
to interest would restrict the deduction for interest if the company failed
to
meet either of two tests: if debt to equity ratios in the U.S. differed from
the
total
debt to equity ratio worldwide and if interest expenses exceed a certain
share
of adjusted income (generally taxable income before the deduction of
interest
and depreciation). The smaller of the excess interest under either test
would
be disallowed, but the percentage has not been specified.
• The
draft indicates that the two extenders, exception from Subpart F of active
financing
and active insurance income and the look-through rules, would be
considered
separately.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 27
Senator Enzi’s Bill (S. 2091)
Senator
Enzi has introduced S. 2091 which is similar in many respects to the Ways and
Means
Discussion
Draft. His bill is a separate bill that does not include a general tax reform
or lowering
of
the corporate rate.69
• The
Enzi proposal provides the same 95% dividend exemption and election
option
for 10/50 companies as the Discussion Draft.
• Foreign
branches would not be treated as subsidiaries.
• Anti-abuse
rules (Subpart F) would be retained, but the inclusion of foreign base
company
sales and service income would be eliminated.
• Capital
gains on the sale of stock would be eligible for the exclusion to the extent
they
would be treated as a dividend under Section 1248 (which treats gains as
dividends
to the extent of earnings and profits).
• Firms
could elect to tax accumulated earnings with a 70% exclusion (a 10.5%
tax)
and no foreign tax credits; otherwise accumulated earnings would be taxed at
full
rates with foreign tax credits allowed when paid out as dividends and these
pre-existing
earnings would be deemed to be paid out first.
• Foreign
tax credits (and deductions for these taxes) associated with exempt
income
would be disallowed.
• The
Enzi bill does not repeal the provision taxing investments of deferred income
in
U.S. property.
• For
anti-base-erosion provisions a version of Option B in the Discussion Draft
along
with a version of the first part of Option C would be included. Income in
countries
with tax rates of half or less than the U.S. rate (17.5%) would be
subject
to tax. However, operations that conduct an active business, with
employees
and officers that contribute substantially, would be excepted except to
the
extent the income is intangible income of the CFC. The CFC’s intangible
income
would be Subpart F income. These rules provide more scope for
exemption
as compared to the rules in the Discussion Draft which would require
exempt
income to carry out activities serving the home country market. The bill
also
includes the first part of Option C, allowing a 17.5% tax rate on intangible
income
(such as royalties) earned by a domestic corporation. Intangible income
would
be placed in a separate foreign tax credit basket.
• The
bill does not contain the thin capitalization rules (such as allocating
interest
between
U.S. firms and their foreign subsidiaries).
• The
bill makes the two extenders, the exception from Subpart F for active
financing
and active insurance income and the look-through rules, permanent. It
also
applies the worldwide interest allocation for purposes of the foreign tax
credit
in 2013, rather than 2021.
69 Ernst & Young has provided a summary of
this bill, “Senator Enzi Introduces and International Tax Reform Bill,”
http://www.ey.com/Publication/vwLUAssets/Senator_Enzi_introduces_an_international_tax_reform_bill/
$FILE/Senator%20Enzi%20introduces%20reform%20bill.pdf, March 1,
2012.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research Service
28
Analysis and Commentary on the
Proposals
Some
insights into issues and trade offs may be noted by observing the difference
between these
proposals.
In addition, the Discussion Draft proposals invited commentary, which has
appeared in
a
number of venues including testimony before a Ways and Means Subcommittee on
Select
Revenue
Measures hearing on November 27, 2011. This section examines the alternative
approaches
in light of the issues discussed earlier and general design considerations.
Repatriation Incentives
While
the Grubert-Mutti proposal has no tax that is triggered by repatriation, the
other two
territorial
proposals do, due to the 5% “haircut” resulting from the proposed 95%
exemption. In
addition,
the Discussion Draft also allows firms to choose an alternate completely tax
free method
of
repatriation since investment in U.S. assets is not taxed, even at a 5% share.
Presumably, the
expectation
is that the tax due to the 5% inclusion in income (1.25% at a 25% rate and
1.75% tax
at
a 35% rate) is too small to matter. At least one commentator, however, has
singled this issue out
as
a potentially serious one indicating that as long as tax planning to avoid even
a small tax is
costless,
firms will undertake it.70 One option for the Discussion Draft, which
would not eliminate
the
small repatriation tax but would eliminate the costless avoidance, would be to
continue to tax
these
transactions, or to tax 5% of them. An approach that could eliminate the
repatriation tax
trigger
arising from the 5% exclusion altogether is to include 5% of income whether
repatriated
or
not, and make dividends entirely exempt.
S.
2091 also has an additional temporary repatriation trigger arising from its
transition rule, which
allows
firms to elect to repatriate under a 70% exclusion without credits, but would
tax dividends
until
any remaining accumulated funds are exhausted. Presumably, firms would
repatriate funds
voluntarily
from low tax jurisdictions, and then repatriate funds from countries with high
foreign
taxes
until the backlog is exhausted.
The
Grubert Mutti proposal does not have any special provision for accumulated
untaxed
earnings
and dividends paid out of those earnings . Basically this provision was not
addressed
although,
as noted above, the authors would expect some transition rule similar to the
other
proposals;
this treatment was not incorporated into their revenue estimates.
Effects on Tax Burden and
Investment
Although
the Discussion Draft leaves a number of options open, its objective to be revenue
neutral
indicates that it is more beneficial to U.S. multinational firms than the
Grubert-Mutti
proposal
that raises revenue. Moreover the Discussion Draft proposes to finance part of
the
revenue
loss through the one time revenue gain from the tax on existing accumulated
earnings.
Senator
Enzi has indicated an intention for his bill to be revenue neutral as well,
although it has
not
been scored.71
70 Jeffery M. Kadet, “Territorial W&M
Discussion Draft: Change Required,” Tax
Notes, January 23, 2012,
pp. 463-464.
71 See Senator Enzi’s press release, at
http://www.enzi.senate.gov/uploads/3.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 29
Some
elements that increase the tax burden on foreign source income (offsetting the
loss from
exempting
dividends and in some cases branch income) are the allocation of deductions and
taxation
of royalties in the Grubert-Mutti proposal and the 5% inclusion of dividends in
the other
two
proposals. The base erosion provisions may or may not increase taxes depending
on which
option
is chosen and the extent to which firms can use the active trade or business
exception to
avoid
the tax. Some of the reason for these differences in revenue effect is that the
5% inclusion
appears
to be significantly smaller than overhead costs (even excluding interest). One
comment
also
noted that the 5% inclusion does not take account of a firm’s individual
circumstances.72
Altshuler
and Grubert estimate that overhead expenses outside of interest and research
expenditures
are 10% of pretax earnings.73 Moreover,
their proposal would disallow the deduction
regardless
of whether dividends are paid out, while the 5% inclusion would apply only to
dividends
paid. Assuming that about 40% of earnings are paid out in a steady state the 5%
provision
would be 2% of total earnings. Thus the provision in the Grubert-Mutti proposal
would
be
about five times the size of the provision in the Discussion Draft and S. 2091.
Presumably
interest would also be significant. The Grubert-Mutti proposal has a direct
allocation
rule
for the parent’s interest presumably based on allocations of assets.74 The proposal does not
spell
out specifics, but interest allocation could be net or gross, and it could
involve only the
parent
interest or worldwide interest. Turning to years of 2006 and 2007, net interest
as a share of
combined
interest and pretax earnings of nonfinancial corporations in the National
Income and
Product
Accounts was 15% in 2006 and 21% in 2007.75
The 2006 measure may be more
appropriate
as a steady state guide since profits had begun to decline in 2007. According
to tax
statistics,
for manufacturing the share was 13% in 2006 and 18% in 2007.76 Gross interest, the
basis
of the current allocation rules for the foreign tax credit limit, would be much
larger, ranging
from
34% to 39% of profits plus interest payments. In a related article, by
Altshuler and Grubert,
the
analysis assumes that debt accounts for a third of the capital stock.77 The Discussion Draft has
thin
capitalization rules that are based on two alternative tests: an allocation
provision for net
interest
based on parent versus subsidiary debt-equity ratios taking into account
worldwide debt
and
an alternative based on an as-yet-unspecified share of adjusted income, so that
the effects on
interest
are uncertain. S. 2091 has no allocation rule.
Grubert
and Mutti could have an allocation for research and development expenditures
but
apparently
do not.78 Thus, they have no provision that addresses
profit shifting from intangibles.
72 Comments of Stephen Shay, KPMG, Will the
U.S. Shift to a Territorial System: A Discussion of Chairman Camp’s
Territorial Tax Draft, http://www.us.kpmg.com/microsite/taxnewsflash/Corporate/2011/tgi-exec-sum-territorialtax.
pdf.
73 Rosanne Altshuler and Harry Grubert, “Where
Will They Go if We Go Territorial? Dividend Exemption and the
Location Decisions of U.S. Multinational Corporations,” National Tax Journal, December 2001, pp. 787-809.
74 The proposal refers to allocating the
parents interest to firms and not worldwide interest, although a worldwide
allocation would be an option.
75 See data from Economic Report of the
President at http://www.gpo.gov/fdsys/pkg/ERP-2012/pdf/ERP-2012-
table15.pdf.
76 Internal Revenue Service,
http://www.irs.gov/taxstats/article/0,,id=170692,00.html. In 2006, the
manufacturing
sector has 247 billion of interest payments, $183 billion of
interest income and $481 billion in net income. In 2007,
these numbers were $304 billion, $203 billion and $468 billion
respectively.
77 Rosanne Altshuler and Harry Grubert, “Where
Will They Go if We Go Territorial? Dividend Exemption and the
Location Decisions of U.S. Multinational Corporations,” National Tax Journal, December 2001, pp. 787-809.
78 Ibid.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 30
If
these costs were included, for 2006 for manufacturing they were 18% of the
total of earnings
and
research costs.79 Neither the discussion draft nor S. 2091
have such an allocation, although
they
have some options that affect base erosion that could address intangibles.
Without
more specific guidelines, it is difficult to determine the share of income that
would be
taxed
under the Grubert Mutti proposal. Using net interest, the ratio for
manufacturing in 2006
relative
to net income is about 15% and the overhead costs add another 10%, taxing about
25% of
income,
whether paid as a dividend or not. In contrast, assuming 40% of income is paid
as a
dividend,
the 5% inclusion in the Discussion Draft and S. 2091 would tax about 2%. At a
35%
rate,
these effects would impose additional taxes of 8.75% (0.25 times 0.35) under
the Grubert
Mutti
plan and 0.7% (0.05 times 0.35 times 0.40).
If
the allocation of interest is made based on worldwide costs (and not just U.S.
parent costs), the
allocation
could be smaller and firms could shift interest costs to their foreign
subsidiaries and
deduct
them so that the effect would be only the difference between the U.S. and
foreign rate. In
addition,
with an overall allocation, this interest cost would presumably be shifted to
high tax
countries.
The United States would still gain revenue but some of it would be offset (from
the
firm’s
point of view) by lower tax payments to foreign countries. At the extreme, only
the
overhead
allocation of 10% would affect taxes, leading to a 3.5 percentage point tax
increase.
Both
the Discussion Draft and S. 2091 include specific anti-base erosion measures
which are not
included
in the Grubert Mutti proposal and these may to some extent substitute for cost
allocation
provisions.
These provisions relate less to investment than to profit shifting and are
discussed in
the
next section.
Incentives
could also be affected by the treatment of royalties whose tax burden would
rise as
excess
foreign tax credits disappear. This higher tax on royalties could encourage
both more
exports
of products with technology embodied (as the cost of exploiting intangibles
abroad
increases).
It could also encourage more research to be performed abroad in low tax CFCs
although
this effect is unclear since such research would not have a benefit as an
investment
(expensing
and the R&D credit) as is the case in the United States.
S.
2091 also provides that royalty income will be taxed at a 17.5% rate, which
reduces the
additional
taxes that would arise from the loss of foreign tax credits on other incomes. A
lower tax
on
royalties is an option in the discussion draft. Under S. 2091, intangibles that
fall under the antibase
erosion
rules would be taxed at the full rate, 35%.
As
noted earlier, none of the shifts in investment are likely to be large relative
to the U.S.
economy.
Thus, even if the provisions induce more research to be performed abroad, the
consequences
would not be likely to be significant.
Artificial Profit Shifting
There
are several different anti-profit shifting regimes discussed in the proposals:
the full
allocation
of deductions in Mutti and Grubert, the interest allocation rules plus one of
three
options
in the Ways and Means Draft, and the combination of components of two of the
three
79 International Revenue Service statistics,
at http://www.irs.gov/taxstats/article/0,,id=164402,00.html.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 31
options
for S. 2091. Although a more detailed discussion is presented below, Table
6 summarizes
the
discussion.
Grubert
and Mutti address artificial profit shifting by allocating deductions,
including overhead
administrative
costs and interest. For interest deductions, this allocation method should
address
the
shifting facilitated through leveraging, although their proposal may only
allocate parent
company
expenses. A more comprehensive approach is to allocate world wide expenses.80 They
discuss
this world wide approach as well, which would lose revenue compared to
allocating only
parent
company costs and could potentially cause an overall revenue loss. For
intangible profits,
they
do not address the tax on income shifted abroad. Rather they disallow a portion
of the
associated
investment costs (research and development costs and other overhead costs such
as
marketing).
Their anti-abuse program has the virtue of simplicity and because an increase
in
profits
abroad triggers a tax (in the form of foregone deductions) it reduces the
incentive to shift
profits
through that effect as well.
Table
6. Summary of Discussion in Text of Base Erosion Provisions of the Proposals
Grubert and Mutti
Allocation of
Deductions
Allocation of overhead costs and interest is simple. It might be
desirable to employ worldwide
allocation. Allocation would automatically impose an additional tax
on shifted profits. Grubert
and Mutti have no provisions to address profit shifting through
intangibles.
Ways and Means Discussion Draft
Interest
restrictions
Worldwide allocation of interest may be effective in dealing with
leverage. The ability to meet
an alternative less restrictive test may undermine the effects; it
is not clear what the purpose of
this alternative is.
Plus Option A Provisions to tax as U.S. connected income intangible
earnings in excess of 150% of costs for
countries with rates below 15% (phased out between 10% and 15%)
would discourage profit
shifting of this nature. It creates an incentive to shift costs to
low tax countries and could
encourage firms to relocate. Measuring effective tax rates and
identifying affected income would
be complicated.
Or Plus Option B Provisions to tax income in countries with rates
below 10% as U.S. income would exclude
Ireland, and would encourage firms to shift to slightly higher tax
rate countries, or perhaps
encourage tax havens to increase taxes, both of which would
increase taxes paid to foreigners.
Measuring effective tax rates could be complicated. Firms may be
able to avoid the U.S. tax
through the home country exception.
Or Plus Option C This provision, which taxes all intangible income
as U.S. income at a lower rate is not triggered
by the country’s tax rate and effectively imposes a minimum tax of
15% on intangible income. It
thus imposes a lower tax rate on income in low tax jurisdictions
but does not induce shifting to
other countries. It also imposes the same tax rate on royalties,
reducing the incentive to shift
these profits into a subsidiary, but compared to a plan without
this feature, encouraging
production abroad. Distinguishing intangible income would be
difficult. This royalty provision
might violate WTO rules against export subsidies.
S. 2091 (Enzi)
No Deduction
Allocation
This bill has no provision for restricting leveraging directly.
80 When the Grubert Mutti proposal was
developed, worldwide allocation was not in the law. Harry Grubert, in a
conversation on July 5, 2012, indicated that worldwide
allocation would be appropriate.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 32
Option B Version Income in countries with taxes less than half the
U.S. rate (17.5%) are subject to U.S. tax, unless
there is an active trade or business. A higher rate encompasses
more countries, including
Ireland. However, it also has an incentive for affected firms to
move income to slightly higher
tax rate countries and involves complications in measuring
effective tax rates. The provision
excepts firms that are making a substantial contribution to a
business, a more easily avoided
rule than the one in the Discussion Draft which allows an exception
only for production for the
home market.
Plus Part of
Option C
Would also tax royalties at 17.5%, which could in some cases
encourage income to be received
as royalties. It would encourage exploitation of intangibles abroad
and might violate the WTO.
Source: CRS analysis of
proposals.
The
Ways and Means Discussion Draft addresses the shifting due to leveraging by
restricting
interest
deductions. They impose the lesser of two restrictions. The first is an
allocation of interest
based
on worldwide interest and assets, much like the Grubert and Mutti approach. The
second is
a
limit on interest relative to modified income, and since the limit is not
spelled out, the extent of
that
restriction is yet to be determined. If a high enough ratio of interest to
modified income is
allowed
then the interest allocation would not be very effective and since modified
income is
prior
to not only interest but depreciation and some other production expenses, the
ratio would
have
to be relatively low to be broadly effective. The effectiveness would need to
be explored
once
a percentage is determined. The value of this alternative is not readily
apparent given that
the
first restriction, the allocation rule, provides a reasonable method. The Enzi
bill has no interest
allocation
provisions.
A
specific base erosion provision outside of interest has not been chosen in the
discussion draft,
and
it is difficult to determine how effective the base erosion proposals are
likely to be. Both
Options
A and Option B hinge on being in a low tax country and the tax rate is
relatively low,
only
10%. Option A, which phases out the U.S. taxation of excess intangibles between
10% and
15%
may only partially affect Ireland, for example, which has a statutory tax rate
of 12.5% and
Option
B would miss it altogether. These tax rates are effective rates, which is
appropriate, but
which
could be difficult to measure.81 Options
A and C require the identification of intangible
income,
which is not necessary for B; this problem has been identified as an important
complicating
factor in several comments.82
By
triggering current taxation of intangibles when the return exceeds 150% of
costs, Option A
provides
an incentive to push deductible development and marketing costs into the CFC, a
point
made
in Ways and Means hearing.83 Once a firm falls into the excess profit
class a dollar of cost
moved
to the CFC will decrease income subject to U.S. taxation by $1.50, while
increasing
taxable
income in the United States by $1.00 (although if the tax code retained the
production
activities
deduction and income were eligible for it, this additional dollar would
increase taxable
income
by $0.91).
81 This measurement problem is pointed out by
Harrington, Subcommittee on Select Revenue Measures, Ways and
Means Committee, November 27, 2011, testimony of John L.
Harrington, at http://waysandmeans.house.gov/
UploadedFiles/Harringtonsrm1117.pdf.
82 This complication of Options A and C is
pointed out by Stephen Shay and Paul Oosterhuis, KPMG, Will the U.S.
Shift to a Territorial System: A Discussion of Chairman Camp’s
Territorial Tax Draft, at http://www.us.kpmg.com/
microsite/taxnewsflash/Corporate/2011/tgi-exec-sum-territorial-tax.pdf
and by Michael Reilly, discussion reported in
Shamik Trivedi, “Agreement on Territorial Plans Unlikely Despite
Commonalities,” Tax Notes, February 20, 2012, pp.
949-950.
83 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, Testimony of T.
Timothy Tuerff, at
http://waysandmeans.house.gov/UploadedFiles/Tuerffsrm1117.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 33
Option
B, which triggers full U.S. taxation of some income in countries with tax rates
below 10%
would
create incentives to move profits to countries with tax rates higher than the
10% level but
lower
than the U.S. 25% level. Ireland is a possibility, but there are many potential
locations
which
might not currently be used as tax havens which would become so, including a
number of
former
eastern block countries. It is also possible that jurisdictions that cater
largely to U.S.
multinationals
would raise their own taxes to prevent U.S. firms from leaving. In either case,
total
U.S.
income (the sum of taxes and company profits) would be reduced because a third
party (the
other
countries) would collect a higher share of U.S. firms profits. Option B also is
formulated as
a
cliff: once the country reaches a trigger level all income is subject to full
U.S. taxes. Option B
exempts
from inclusion income derived in the home country (an active trade or business
with
income
derived from the sale of property for use in the country or services provided
in the
country).
These rules may be exploited by firms to avoid the tax.
The
drawbacks of option B could also potentially affect option A as well. Since the
lower taxes
would
apply to profits equal to 150% of costs, the lower taxes paid in countries with
rates below
10%
on this portion of profits would have to be traded off against higher taxes on
the excess
profits.
However, in countries where the costs are small relative to profits firms might
also have
incentives
in this case to shift locations.
Option
C, which applies this system only to intangibles and is not triggered by a
specific tax rate
would
also have the merit of not inducing undesirable behavioral changes. Option C
would also
apply
this lower tax to royalties, although at least one analysis has suggested that
a lower tax rate
on
royalties might violate WTO rules on export subsidies.84 Several critics have pointed out the
complication
of measuring intangible income which would be a drawback. However, it would
still
require the measurement of affected income, adding complexity.
The
purpose of option B could be accomplished is a way that does not encourage
these
undesirable
behavioral responses by imposing a minimum (combined U.S. and foreign) tax on
all
foreign
source income. Consider, for example, the 60% share of income taxed that
comprises the
second
half of Option C. If a 15% minimum tax were imposed, it would only affect
income in
those
countries with effective tax rates of below 15% but it would not produce
incentives to move
to
a higher tax country.
Option
B does appear to have relatively effective provisions defining an active
operation that can
avoid
the tax in the Ways and Means Discussion Draft, although whether companies
could work
around
them remains to be seen. The Enzi bill has a weaker rule, which would might
more easily
allow
firms to justify an exception to the tax authorities and to the courts. The
Enzi bill provision
is
triggered by a higher tax rate, which should capture Ireland.
One
witness at the Ways and Means Hearing also noted that there is no distinction
in the
Discussion
Draft between intangibles created in the United States and in other foreign
countries:
any
intangible income could trigger a U.S. tax even if developed outside the United
States.85
84 Kristen A. Parillo, “Camp Plan Would Likely
Violate WTO Rules, Buckley Says,” Tax
Notes, December 12, 2011,
pp. 1327-1328.
85 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, testimony of David
G. Noren, at
http://waysandmeans.house.gov/UploadedFiles/Norensrm1117.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 34
Option
C of the Ways and Means Discussion Draft and S. 2091 also contains a reduced tax
rate
for
royalties. Under Option C, royalties would be taxed at the same rate as
intangible income
generated
inside the CFC which would eliminate the incentive to shift newly taxed
royalties into
tax
exempt CFC income. If two thirds of royalties were exempt before due to
sheltering by
foreign
tax credits, this change would be a slight relative tax increase (since 40% is
taxed), but if
the
share is lower due to small excess credits and elimination of the splitter
rules it could be a tax
cut.
Similar points could be made about S. 2091.
Transition
The
Grubert-Mutti proposal appears to exempt dividends regardless of their source,
a view that is
probably
consistent with their emphasis on reducing tax complexity, such as planning
around
repatriation.
This approach provides a windfall benefit. However, as the Grubert and Mutti
study
is
a general outline, the authors may simply not have addressed transition issues.
One of the
authors
has indicated that it would be appropriate to impose a lower tax on the
accumulated
unrepatriated
earnings in an approach similar to the Ways and Means Discussion Draft.86
The
Ways and Means Discussion Draft would tax all accumulated earnings before
implementation
of the reform, but with an 85% exclusion, which may or may not provide a
windfall
since it might largely apply to earnings that would probably never be
repatriated. These
earnings
would not have to be actually repatriated, but could be deemed repatriated, a
benefit that
is
important if these funds are tied up in illiquid investments. Taxes would be
offset by a
proportional
share of foreign tax credits. In a steady state, most accumulated earnings,
based on
past
evidence and new view theory would be earnings that are permanently reinvested.
However,
since
earnings may have accumulated at higher rates through anticipation of another
repatriation
holiday,
more of these earnings may be planned for distribution.
One
critic suggests that the deemed repatriation provision which is extended to
individuals as
well
may not be appropriate for taxpayers not eligible for the dividend exemption.87 Another
suggests
that firms may have trouble measuring the total amount of unrepatriated
earnings.88
S.
2091 has a repatriation tax that differs from the Ways and Means provision in
that it is elective
on
a CFC by CFC basis, the exclusion is smaller at a 70% exclusion and no foreign
tax credits
would
be allowed. However, for income that is not elected to be taxed, the dividend
relief would
not
occur until these accumulated earnings are exhausted. Since firms might
eventually wish to
repatriate
earnings, this rule should create an incentive to repatriate, however, the
elective aspect
allows
firms not to repatriate if their conditions are such that a move of this nature
would be
difficult
(i.e., lack of funds to pay the tax).
86 Conversation with Harry Grubert, July 2,
2012.
87 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, testimony of John L.
Harrington, at http://waysandmeans.house.gov/UploadedFiles/Harringtonsrm1117.pdf.
He notes that the purpose may
be able to deal with individuals transferring their earnings to
corporate form, but suggests that should be dealt with in a
more targeted fashion.
88 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, testimony of Paul
W. Oosterhuis, at
http://waysandmeans.house.gov/UploadedFiles/Oosterhuissrm1117.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 35
Current
tax treatment is governed in some respects by tax treaties and these treaties
may now
come
into conflict with the new proposed rules. Interactions with treaties would
need to be
addressed.
An
issue to be determined is the treatment of foreign tax credits and losses that
have been carried
over.
For the Grubert-Mutti proposal and the Ways and Means Discussion Draft, which
are aimed
at
a full break from the old system, it seems appropriate to allow foreign tax
credit carryovers to
lapse
(if any foreign tax credit carryovers remain after the taxation of accumulated
earnings). That
is
apparently the intent of the deemed repatriation tax.89 S. 2091 would presumably continue
carryovers
for entities not covered (such as branches) and tax credits associated with
accumulated
income
not yet taxed. Treatment of losses under the Discussion Draft has not been
addressed, but
presumably
would continue under S. 2091 which continues aspects of the pre-existing
system.
Administrative and Technical
Issues
Many
of the major rules discussed above would complicate tax administration. The
Grubert-Mutti
proposal
appears to involve the least amount of complication as it has a simple
exclusion,
somewhat
reduces the scope of Subpart F, and has a straightforward anti-abuse provision
in the
form
of the allocation of deductions. There is no scope for a repatriation tax.
Although the Ways
and
Means Discussion Draft is not fully fleshed out, it retains a small
repatriation tax that could
lead
to tax planning (the 5% inclusion of dividend income), and its anti-abuse
provisions could be
quite
complicated. S. 2091 could also potentially lead to a continued repatriation
incentive.
This
section addresses some other specific issues that have technical and
administrative
implications.
Including Branches
Including
branch company income under the territorial rules is contained in two of the
proposals,
Grubert
and Mutti and the Ways and Means Discussion Draft, but not in S. 2091. There is
a good
reason
for including branches in the scope of the territorial tax, since, if branch
income is not
allowed
or if firms can opt out, then firms could continue to use branches versus
subsidiaries for
tax
planning, to allow the recognition of losses but not positive earnings.
Moreover, while there
are
non-tax reasons for operating as a branch, including branches would equalize
the treatment of
branch
and subsidiary operations.
Nevertheless,
one comment suggests that the approach in the Discussion Draft, which treats
branches
as if they are CFC’s subject to all of the other provisions of the proposal
comes with
additional
complications. It is difficult to: measure income of an entity that does not
legally exist
as
if it were separate, determine when a foreign branch exists as designed in the
proposal,
determine
the formation or liquidation of an operation that is not a separate entity, and
address the
rules
that apply to intra-company payments. In addition, firms might shift to
operating as a
partnership.
This comment suggests that branch income simply be exempt from the tax without
defining
them as CFCs90 Another comment raises a number of specific
tax issues that need to be
89 See comment of Ray Beeman , KPMG, Will the
U.S. Shift to a Territorial System: A Discussion of Chairman
Camp’s Territorial Tax Draft, at
http://www.us.kpmg.com/microsite/taxnewsflash/Corporate/2011/tgi-exec-sumterritorial-
tax.pdf.
90 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, testimony of John L.
(continued...)
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 36
addressed
when branches are included, including whether taxes will be triggered by
reorganization
and the treatment of inter-branch payments.91
10/50 Election
The
Grubert Mutti proposal includes 10/50 corporations in their exemption system,
while the
Ways
and Means Discussion Draft and S. 2091 allow it as an election. (Recall that a
10/50
company
is one where the corporation has a 10% or more share but the company is not
controlled
by
five or less 10% U.S. shareholders). Presumably companies would prefer to elect
the exempt
treatment
especially as they will lose the foreign tax credits associated with dividends.
One
comment
suggested that 10/50 corporations that wish to elect inclusion may have
difficulties
because
they will become subject to Subpart F rules but may not be able to obtain the information
on
Subpart F income because they do not control the firm. In addition, 10/50 firms
may not be
able
to compel the cash dividend payments needed to pay tax given the tax on
accumulated
earnings
under the Ways and Means Discussion Draft,92
and may not be able to determine the size
of
those accumulated earnings.93 A
concern was also expressed that the tax on accumulated
deferrals
would include income generated before the taxpayer purchased shares in the
company.94
In
S. 2091, a similar argument could be made about the elective repatriation,
which these firms
may
not be able to take advantage of.
Foreign Tax Credit
Revisions
The
Ways and Means Discussion Draft eliminates foreign tax credits for CFC’s,
branches, and
10/50
corporations except for those associated with Subpart F income. It also
eliminates the
foreign
tax credit baskets, splitter rules, and allocation of indirect expenses to
foreign source
income
(including interest allocation rules). One comment suggests that these changes
are
problematic
because individuals will still be eligible for foreign tax credits.95 Another adds that
these
changes in the foreign tax credit would encourage countries to reinstate
foreign withholding
tax
and abrogate treaties because the changes effectively eliminate the limits of
current law that
credits
are limited to foreign source income.96
(...continued)
Harrington, at
http://waysandmeans.house.gov/UploadedFiles/Harringtonsrm1117.pdf.
91 Subcommittee on Select Revenue Measures, Ways
and Means Committee, November 27, 2011, testimony of T.
Timothy Tuerff, at
http://waysandmeans.house.gov/UploadedFiles/Tuerffsrm1117.pdf.
92 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, testimony of John L.
Harrington, at
http://waysandmeans.house.gov/UploadedFiles/Harringtonsrm1117.pdf .
93 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, , testimony of Paul
W. Oosterhuis, at
http://waysandmeans.house.gov/UploadedFiles/Oosterhuissrm1117.pdf.
94 Report on comment of Jose Murillo at an
Ernst and Young Conference, Kristen A. Parillo and Marie Sapirie,
“Territorial Plan Drafters Aware of Transition Concerns,” Tax Notes, November 14, 2011, pp. 810-812.
95 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, testimony of John L.
Harrington, at
http://waysandmeans.house.gov/UploadedFiles/Harringtonsrm1117.pdf.
96 Kristen A. Parillo, “Camp Plan Would
Dramatically Affect Withholding, Buckley Says” Tax Notes, November 21,
2011, pp. 948-949, reporting comments by John Buckley.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 37
Thin Capitalization Rules
and Interest Allocation
One
comment raised the question of whether strengthened thin capitalization rules
that limit debt
would
be extended to U.S. subsidiaries of foreign parents (where presumably weaker
rules
already
apply), or at least that intentions in this area might need to be made clear.97 Although the
legislation
is focused on U.S. multinationals and their foreign operations, profit shifting
can also
occur
across foreign parents and their U.S. subsidiaries, the current focus of thin
capitalization
rules.
Another
comment pointed out that with more restrictive interest allocation rules firms
might want
to
shift borrowing abroad so that interest could be deducted in other
jurisdictions, but that this
change
might increase borrowing costs.98 One
option that might be considered is to allow loans
from
the parent to foreign subsidiaries at the borrowing rate of the parent or allow
the parent to
guarantee
subsidiary loans without triggering effective dividends.
Continuing Subpart F
Some
discussion of the treatment of the existing anti-abuse rules under Subpart F
has occurred. At
least
one commentator questions why Subpart F, which was developed as a general
anti-deferral
provision,
should continue as is with respect to certain types of income, when income is
now
generally
exempt. One example is foreign to foreign base company income relating to sales
and
services,
which is active income.99
Grubert
and Mutti suggest that Subpart F should be retained to address profit shifting
but
modified
by eliminating taxes on dividends and also on deemed dividends from investments
in
the
United States. The Ways and Means Discussion Draft makes these two changes
although they
do
not account for the 5% inclusion in income for either. They indicate a further
consideration of
Subpart
F will be made. Grubert and Mutti suggest that the case for other rules such as
the foreign
base
company rules relating to sales and services and interest would be strengthened
under a
territorial
tax. Presumably they are referring to income shifted out the United States. S.
2091,
however,
specifically excludes this income from Subpart F.
Grubert
and Mutti prepared their analysis before check-the-box rules (and the
look-through rules)
that
allow CFC’s to disregard their related foreign subsidiaries, which have
undermined Subpart
F,
became so important. The Ways and Means Discussion Draft indicates that these
issues will be
considered
separately and S. 2091 would make the look-through rules (as well as the
exclusion of
active
financing income), currently part of extenders and having expired after 2011,
permanent
One
comment suggested that tax reform should address the leakage in Subpart F
including checkthe-
box
and the look-through rules100 At the same time, one of the concerns about
check the box
97 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, testimony of John L.
Harrington, at
http://waysandmeans.house.gov/UploadedFiles/Harringtonsrm1117.pdf.
98 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, Testimony of T.
Timothy Tuerff, at
http://waysandmeans.house.gov/UploadedFiles/Tuerffsrm1117.pdf. See also Paul
Oosterhuis, ,
KPGM, Will the U.S. Shift to a Territorial System: A Discussion
of Chairman Camp’s Territorial Tax Draft, at
http://www.us.kpmg.com/microsite/taxnewsflash/Corporate/2011/tgi-exec-sum-territorial-tax.pdf.
99 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, testimony of John L.
Harrington, at
http://waysandmeans.house.gov/UploadedFiles/Harringtonsrm1117.pdf.
100 Kristen A. Parillo, “Camp Plan Would
Dramatically Affect Withholding, Buckley Says” Tax Notes, November 21,
2011, pp. 948-949, reporting comments by Jeff Vandervolk.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 38
and
look through rules is that the result would not be greater U.S. tax collections
but an increase
in
taxes paid to other countries. For example, if a subsidiary’s interest payments
from loans to its
own
high tax subsidiary could not longer be disregarded for purposes of Subpart F
with an end to
these
rules, the response could be to no longer make the loan causing additional tax
to be
collected
by the higher tax foreign country. This outcome would not be beneficial for the
U.S.
overall
since it would reduce the sum of U.S. private profits and U.S. taxes. One
comment, for
example,
notes that exemption would cause firms to have every incentive to reduce foreign
taxes
paid,
and broadening of Subpart F rules should not undo that incentive.101
A
final comment about Subpart F income is that, since this income is deemed
repatriated and not
actually
paid out, there will be an additional tax under the Discussion Draft and S.
2091on 5% of
income
when these earnings are actually paid out as dividends.102 Thus, 5% of income would be
subject
to double taxation.
Revenue Consequences
The
Grubert-Mutti proposal is projected to raise revenue on a permanent basis,
although the gain
is
small, less than 2% of corporate revenues. Both the Ways and Means Discussion
Draft and S.
2091
aim to be revenue neutral over the budget horizon. However, both also rely on a
one time
revenue
gain from taxing existing accumulated earnings. Since this gain is transitory,
these
proposals
will lose revenue on a permanent basis. Since the proposals have not been
scored, there
is
no way to determine how large the permanent revenue loss would be, but it is
likely to also be
small.
Alternatives to a Territorial
Tax
As
noted in the prior discussion, there are alternatives to a territorial tax that
could address issues
associated
with repatriation and profit shifting as effectively or perhaps more
effectively than the
territorial
tax provisions. These alternatives fall into three main groups: ending deferral
and
possibly
limiting cross-crediting to move closer to a true worldwide system, reforming
the
existing
system in more limited ways, particularly to address profit shifting, and a hybrid
between
ending
deferral and a territorial tax, such as a minimum tax, which would eliminate
the
repatriation
tax trigger. By traditional theory all of these approaches would probably
attract
capital
back to the United States and improve efficiency in the allocation of capital,
although they
may
create a need to further address shifting of headquarters.
These
proposals are summarized briefly. Many of them are addressed in more detail in
other CRS
reports.103 Note that many of the same issues that
arise with a territorial tax would need to be
addressed
in some cases, such as dealing with the transition, and dealing with operations
outside
of
CFCs.
101 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, testimony of Paul
W. Oosterhuis, at
http://waysandmeans.house.gov/UploadedFiles/Oosterhuissrm1117.pdf.
102 Subcommittee on Select Revenue Measures,
Ways and Means Committee, November 27, 2011, Testimony of T.
Timothy Tuerff, at
http://waysandmeans.house.gov/UploadedFiles/Tuerffsrm1117.pdf.
103 CRS Report RL34115, Reform of U.S. International
Taxation: Alternatives, by Jane G. Gravelle; CRS Report
R40623, Tax Havens: International Tax
Avoidance and Evasion, by Jane G. Gravelle.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 39
Ending Deferral
Ending
deferral, as shown in Table 5,
is estimated to raise $18.4 billion in FY2014. A deferral
option
is also included in the CBO budget options study and is estimated to raise
$11.1 billion in
revenue
in FY2014.104 The smaller revenue gain may reflect a
provision that eliminates the
current
interest allocation provision for purposes of the foreign tax credit limit. It
would tax
income
of foreign subsidiaries, while allowing foreign tax credits as in current law.
Current
taxation
would eliminate any disincentive to repatriate, and would also reduce the
benefits and
scope
for profit shifting. Cross-crediting would still be available. It would be more
consistent
with
efficient resource allocation, although issues of shifting headquarters might
need to be
addressed
further. As with territorial tax proposals, transition issues would arise which
could be
addressed
in a fashion similar to that in the Ways and Means Discussion Draft. The
revision
would
require the measurement of earnings under U.S. law, which could add complexity,
although
such measurement would also be needed for most base erosion measures as well.
As
with
the territorial tax, issues would arise in extending the treatment to 10/50
corporations that
have
a large U.S. shareholder but are not controlled by a group of large U.S.
shareholders, since
information
on earnings may not be available. This change would, however, permit the
elimination
of Subpart F.
Ending Deferral and Ending
Cross-Crediting Via a
Per Country Limit
A
greater level of taxation and a more effective provision to discourage
artificial profit shifting,
which
would also eliminate disincentives to repatriate, is to combine ending deferral
with a per
country
limit on foreign tax credits, preventing tax haven income from being shielded
by foreign
tax
credits. This proposal is part of S. 727, the Wyden and Coats general tax
reform plan, and is
combined
with a repatriation holiday similar to that enacted in 2004. This provision was
estimated
to raise $64.3 billion in FY2014 (see Table 5).
This larger revenue gain aided in the
reduction
of the corporate tax rate in that bill to 24%. This provision would require
country-bycountry
measures
of foreign taxes paid as well as income (focusing on income earned within that
country
and not adjusting for intercompany dividends). Provisions would need to be
enacted to
prevent
firms from using holding companies to avoid the per country limit and check the
box and
look
through rules would probably need to be revised.
Measures to Modify the Current
System: the President’s Proposals
The
President has made several proposals that address international tax issues.
The
FY2013 budget outline contains several revisions which overall would raise
$16.8 billion in
FY2014.
Note that some of these are complex to explain, and are described in more
detail in a
Treasury
Department document.105
104 Congressional Budget Office, Reducing the Deficit: Spending
and Revenue Options, March, 2011, p. 186, at
http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/120xx/doc12085/03-10-reducingthedeficit.pdf.
105 See U.S. Department of Treasury, General Explanations of the
Administration’s FY2013 Revenue Proposals,
February 2012, http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2013.pdf.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 40
• Disallowing
interest deductions of parent companies to the extent that income is
deferred.
This provision is similar to the allocation proposal in Grubert and Mutti
but
confined to interest and affecting deferred income. An earlier tax reform
proposal
by Chairman Rangel (H.R. 3970 in the 110th
Congress, 2007) would
have
allocated a broader range of deductions, not just interest. This provision
would
reduce, although not eliminate, the disincentive to repatriate. ($5.9
billion).
• Limiting
foreign tax credits available to the same share of total credits as the
overall
share of income that is repatriated. This approach would limit tax
minimization
by repatriating income to absorb foreign tax credits. ($5.5 billion).
• Treating
excess intangibles profits as U.S. income, the same provision as Option
A
is the Ways and Means Discussion Draft, although the budget proposal does
not
specify the magnitude of the cost mark-up. ($2.5 billion). The proposal would
also
clarify some rules relating to the valuation of intangibles. ($0.1 billion).
• U.S.
insurance companies can reduce taxes by purchasing reinsurance from
foreign
affiliates, with a deduction of the premiums by the U.S. firm but no tax
on
the income of the foreign affiliate. This provision would disallow these
deductions
under certain circumstances. ($0.2 billion).
• Stricter
limits on interest deductions would apply to U.S. subsidiaries of firms
that
inverted (moved their headquarters abroad) prior to the anti-inversion rules
adopted
in 2004. ($0.4 billion).
• Foreign
taxes paid in part to receive a benefit (i.e., the firm is paying a tax in a
dual
capacity) would not be credited unless the income tax is generally imposed
on
the country’s own residents as well as foreign persons. The current rule does
not
require the tax to be imposed on the country’s residents. This provision
typically
relates to taxes being substituted for royalties in oil producing countries.
($1.0
billion).
• A
codification of regulations that impose on a foreign corporation or nonresident
alien
tax on gain from a partnership interest to the extent the gain reflects
property
effectively connected with U.S. business. ($0.2 billion).
• A
provision to prevent a foreign affiliate from avoiding characterization as a
dividend
by making the distribution through a related affiliate with limited
earnings
and profits, causing the distribution to adjust the cost basis of stock
rather
than create dividend income. ($0.3 billion).
• Preventing
foreign tax credits from offsetting tax on the gain from certain types
of
asset acquisitions. (0.1 billion ).
• A
provision that prevents the reduction of earnings and profits without the
reduction
in foreign tax credits that can currently occur in some transactions.
($20
million).
The
Administration also presented a framework for tax reform that mentioned five
elements: the
allocation
of interest for deferred income (first bullet point above), a tax on excess
intangibles
(third
bullet point), a minimum tax on foreign source income in low tax countries,
disallowing a
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 41
deduction
for the cost of moving abroad and providing a 20% credit for costs of moving an
operation
from abroad to the United States.106
The
minimum tax on foreign source income, which would be a potentially important
provision, is
not
discussed in detail. A minimum tax that could be imposed in the framework of an
effective
territorial
system is discussed below.
Partial or Targeted End to
Deferral
A
variety of more limited ways of reducing or partially eliminating deferral
include eliminating
deferral
for specified tax havens, eliminating deferral in countries with tax rates that
are below the
U.S.
rate by a specified proportion, eliminating deferral for income from the
production of goods
that
are in turn imported into the United States, eliminating deferral for income
from the
production
of goods that are exported to any other country from the foreign location, and
requiring
a minimum payout share. These provisions would partially achieve the goals of a
general
elimination of deferral.107
Formula Apportionment
Another
approach to addressing income shifting, whether in the current system or a
revised
territorial
system, is through formula apportionment. With formula apportionment, income
would
be
allocated to different jurisdictions based on their shares of some combination
of sales, assets,
and
employment. This approach is used by many states in the United States and by
the Canadian
provinces
to allocate corporate income. In the past, a three factor apportionment was
used, but
some
states have moved to a sales based system. Studies have estimated a significant
increase in
taxes
from adopting formula apportionment.108
The ability of a formula apportionment system to
address
some of the problems of shifting income becomes problematic with intangible
assets
which,
unlike production income, cannot be allocated based on tangible assets.109 There is also a
problem
of coordinating with other countries so that income would not be double-taxed
or never
taxed.110
106 The President’s Framework for
Business Tax Reform: A Joint Report by the White House and the Department of
the
Treasury, February 2012,
http://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-Frameworkfor-
Business-Tax-Reform-02-22-2012.pdf.
107 CRS Report R40623, Tax Havens: International Tax
Avoidance and Evasion, by Jane G. Gravelle This reports also
discusses a variety of minor changes in rules including foreign
tax credit provisions.
108 Slemrod and Shackleford estimate a 38%
revenue increase from an equally weighted three-factor system Douglas
Shackelford and Joel Slemrod, “The Revenue Consequences of Using
Formula apportionment to Calculate U.S. and
Foreign Source Income: A Firm Level Analysis,” International Tax and Public
Finance, vol. 5, no. 1, 1998, pp. 41-57.
Clausing and Avi-Yonah estimate a 35% increase in taxes using
sales. Kimberly A. Clausing and Reuven A. Avi-
Yonah, Reforming Corporate Taxation in a
Global Economy : A Proposal to Adopt Formulary Apportionment,
Brookings Institution: The Hamilton Project, Discussion paper
2007-08, June 2007.
109 These and other issues are discussed by
Rosanne Altshuler and Harry Grubert, “Formula Apportionment: Is it Better
than the Current System and Are There Better Alternatives?”
Oxford University Centre for Business Taxation,
Working paper 09/01.
110 CRS Report R40623, Tax Havens: International Tax
Avoidance and Evasion, by Jane G. Gravelle, for further
discussion.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 42
Hybrid Approaches: Minimum Tax,
Partial Territorial Tax
Using
the basic territorial approach embodied in the Ways and Means Draft Discussion,
it would
be
possible to generate a relatively straightforward hybrid approach, by a
modification of Base
Erosion
Option B to impose a simpler general minimum tax with no exceptions for active
trade or
business.
Such a revision would technically begin with an elimination of deferral and per
country
foreign
tax credit limit. Income, however, would be taxed at a lower tax rate. This
approach
would
avoid the incentives to shift to a slightly higher tax jurisdiction. Moreover,
it would be
simpler,
because it would not require any measure of a specific type of income, would
not require
a
measure of effective tax rate, and would not require a determination of the
type of activity to
allow
an exception. It would use U.S. rules for measurement of income, but would
apply a lower
statutory
rate to taxable income. Foreign tax credits would need to be allowed on a
country by
country
basis. For example, suppose the statutory rate to be applied were half the U.S.
rate, or
given
current rates, 17.5%. In that case any income from a country with an effective
tax rate on
taxable
income at that level (and probably a lower effective rate overall) would not be
subject to
U.S.
tax. Such a tax regime would only affect tax havens and low tax jurisdictions.111
An
alternative would be to require income to be repatriated (or deemed
repatriated) but subject
some
share of it to U.S. tax and exempt the rest. An appropriate share of foreign
tax credits would
be
disallowed. For example, if half of income is taxed, the system would be 50% a
territorial tax
and
50% a world wide tax without deferral. Foreign tax credit limits could be
allowed on an
overall
basis or country by country. This approach bears some resemblance to the
foreign tax
credit
pooling proposal in the President’s budget except there is no discretion about
repatriation.
Comments
made on the combining of a minimum tax with a territorial system suggested that
the
tax
rate would be important, with two observers suggesting a rate of 20%, similar
to the rate used
by
Japan, and indicating that a 10% tax rate is too low.112
Both
of these proposals would have the effect of eliminating the repatriation
disincentive as well
as
reducing the incentive to shift profits (or at least the cost). Unlike
proposals to tax this income
at
full U.S. rates, such a minimum tax is less likely to shift income to other
jurisdictions that have
higher
rates than the United States.
In
any proposal aimed at tax havens, there is a possibility that the haven or low
tax country would
raise
its taxes and capture some of the profits. This problem is more significant
with a minimum
tax
that it would be with full elimination of deferral, which would remove the
incentive to profit
shift
altogether. Tax havens attracting other country’s firms might be reluctant to
raise taxes and it
might
be possible to deny credits for taxes that are increased for that purpose.
111 A 2000 Treasury Study proposed a similar
treatment and also discussed a tax at a low rate without foreign tax
credits. See U.S. Department of Treasury, The Deferral of Income
Earned Through U.S. Controlled Foreign
Corporations, p. 91, at
http://www.treasury.gov/resource-center/tax-policy/Documents/subpartf.pdf.
112 These observations were made by Reuven
Avi-Yonah and Edward Kleinbard, reported in Julie Martin, “Minimum
Tax on Multinationals,” Tax
Notes, March 19, 2012, pp. 1498-2000.
Moving to a Territorial
Income Tax: Options and Challenges
Congressional Research
Service 43
Appendix. History of
International Tax Rules
As
this history indicates, most of the proposals made over the years, whether
adopted or not,
moved
not toward a territorial tax and a reduction in taxation of foreign source
income, but
toward
a worldwide tax and increased taxation.
Deferral
of tax on income from foreign incorporated subsidiaries dates from the earliest
years of
the
income tax based reflecting legal principles of the time. The earliest income
tax allowed a
deduction
for foreign taxes, which was replaced by an unlimited credit in 1918. In 1921
an
overall
limit on the foreign tax credit. similar to current law, was adopted. Beginning
in 1932, a
per
country limit was allowed or required, although regulations that sourced income
to holding companies allowed firms to achieve overall limits on their own. The
per country limit was
eliminated
in 1976, although income was sorted into passive and active baskets to prevent
this
type
of cross-crediting.
A
number of proposals for changing the system were made but were not (or have not
yet been)
adopted.
Eliminating deferral was proposed by President Kennedy and President Carter.
The
Kennedy
proposals led to the anti-abuse rules (Subpart F) that tax passive and easily
shifted
income
currently.
The
Burke Hartke proposal in the 1970s would have repealed deferral and allowed a
deduction
rather
than a credit for foreign taxes. A per country limit was proposed by the Reagan
Administration
as part of the Tax Reform Act of 1986, but the legislation expanded the number
of
baskets
from two to several instead. The baskets were reduced to two again in
legislation in 2004.
The
main consequence according to tax data, was to include income from financial
services in the
general
basket.
Legislative
proposals which would have increased taxation of international income by
allocating
parent
company expenses, such as interest, to deferred income and not allowing it as
well as
allowing
overall foreign taxes to be considered Proposals similar to those of President
Obama
were
included in tax reform legislation proposed by then Ways and Means Committee
Chairman
Rangel
in 2007. A predecessor to the Wyden Coats bill was the Wyden Gregg bill in the
111th
Congress.
International tax provisions are discussed in detail, through 1989, in William
P.
McClure
and Herman B. Bouma, “The Taxation of Foreign Income from 1909 to 1989: How a
Tilted
Playing Field Developed,” Tax Notes,
June 19, 1989, pp. 1379.
www.irstaxattorney.com (212) 588-1113 ab@irstaxattorney.com
No comments:
Post a Comment