Should the US adopt a territorial tax system?

House Republicans, former GOP presidential hopeful Mitt Romney, and the chairs of President Obama’s 2010 fiscal commission, Erskine Bowles and Alan Simpson, have all called for changing the way the U.S. taxes multinational corporations. The concept: Shift from a system where U.S. firms pay U.S. tax on their worldwide income to one where they’d pay U.S. tax only on what they earn at home—a structure known as a territorial system. A territorial system would accomplish this by removing the current tax that U.S. multinationals pay, net of foreign income tax credits, on dividends that their foreign affiliates repatriate to the U.S. parent company.

Backers of a territorial tax, including CEOs of many multinationals themselves, argue that the current worldwide system puts U.S. firms at a competitive disadvantage since they must pay the high U.S. tax rate on repatriated profits earned by their affiliates in low-tax countries, while multinationals based in territorial countries pay only the local tax rate on these profits. They also argue that since nearly all of the rest of the world uses a territorial system, it only makes sense for the U.S. to follow suit. The United Kingdom and Japan are the latest nations to eliminate their taxes on repatriated dividends.

These are compelling claims but for one problem: Existing territorial systems are in fact hybrids that include elements of a worldwide tax. And the current U.S. system is itself a mix of worldwide and territorial systems, in large part because it allows U.S. companies to defer tax on foreign income until they repatriate those earnings back to the U.S.

Any new system in the U.S. would almost certainly be a hybrid as well. As a result, the benefits to U.S.-based multinationals would vary widely. Some firms would come out ahead, but others would not. 

While some worry about relatively high U.S. taxes on foreign source income, others worry that some U.S multinationals pay little tax on their domestic income. Multinational companies can shift their reported income from the U.S. to low-tax jurisdictions by allocating interest expenses and other fixed costs to domestic operations and manipulating the prices they report on intercompany transactions (transfer prices). This erodes the domestic tax base, especially for companies with large amounts of intangible assets such as patents, technical know-how, and brand identification. There is no easy way for tax authorities to determine what price companies should charge their affiliates for the use of these assets.

All countries have rules to protect their domestic corporate tax base. Transfer pricing rules and limits on interest deductibility (“thin capitalization” rules) curb income shifting. Other rules depart from a pure territorial system by requiring companies to pay an immediate tax on passive income accrued in foreign jurisdictions or by imposing a minimum tax on income from tax havens. For instance, the U.S. “subpart F” rules apply accrual taxation to portfolio investments and certain other foreign-source income.

While the United Kingdom and Japan have eliminated their taxes on repatriated income, they are also re-assessing their taxes on foreign accrued income. Japan taxes on a current basis foreign income that is subject to local tax rates of less than 20 percent. The U.K. limits the deductibility of interest expense against U.K income and is considering reforming rules for taxing accrued foreign profits.

U.S. lawmakers are trying to find the same balance. House Ways & Means Committee Chairman Dave Camp (R-MI) has proposed a territorial tax that would exempt 95 percent of foreign dividends received. But he’d also tighten subpart F and enact new thin capitalization rules. In addition, he’s considering three options to prevent base erosion –a tax on excess returns (similar to a proposal by President Obama), a version of the low effective tax rate test used by Japan, and inclusion in subpart F of intangible income from low-tax countries.

In practice, going territorial would eliminate all or most of the tax on repatriated dividends from foreign affiliates. But to counter increased incentives to shift reported profits overseas, the move to territorial could also include new rules to prevent income shifting and increased accrual taxation of some foreign source income.

These changes would eliminate the lock-in for repatriated profits, but could raise the tax burden on profits left overseas. Such a switch could increase economic efficiency because the lock-in of funds overseas imposes costs on multinationals, while producing no revenue for the U.S. Treasury. But would this benefit U.S. multinationals? Some corporations will indeed benefit from the chance to bring back their overseas profits without paying today’s repatriation tax. But others, who have learned how to avoid tax on their intangible profits under the current rules, may find themselves paying more. As with much else, the devil is in the details. Some corporations may regret getting what they wished for.