Rethinking U.S. Taxation of Overseas Operations: Subpart F, Territoriality, and the Exception for Active Royalties

November 22, 2011

For a PDF of the full study, click here. A summary of the report and the key findings are below.

Tax Foundation Special Report No. 197

Key Findings

• A conflict between those who seek to discourage tax sheltering by requiring U.S. firms to pay taxes on all their activity ("worldwide" system), and those who seek to only tax corporate activity in the U.S. and leave overseas activity to other coun­tries ("territorial" system), led to the enactment of the poorly designed compromise IRS Code Subpart F in 1962.

• Under Subpart F, "active" income can be deferred from U.S. tax until repatriated home, while "passive" income (royalties, interest, dividends) is generally subject to immediate U.S. taxation.

• Since 1996, "check the box" regulations have mitigated many of the harmful effects of Subpart F but political pressure to expand U.S. taxation of overseas activity continues.

• As one example of the complexity of Subpart F, royalty income from active business operations involving related firms cannot be deferred even though it by definition cannot be tax-haven activity.

• The U.S. should consider moving toward a territorial system, and in the meantime should review Subpart F for policies that discourage legitimate overseas business activity.

 Introduction

The United States produces a third of the world's wealth but contains less than 5 percent of the world's population. This disparity pushes many U.S. businesses and entrepreneurs to embrace globalization to improve productiv­ity and expand market reach. Large and small businesses alike are increasingly using the tools of faster information, cheaper transporta­tion, and overseas workforces that blur the traditional notions of taxes and services based on geographic lines.

The U.S. government can effectively pro­mote this dynamism and growth with a tax system that taxes profits earned in the United States but leaves taxation on activity occurring in other countries to those other countries. Instead of pursuing this economic concept of neutrality, however, the U.S. government seeks to tax the profits of U.S. corporations wherever in the world they are earned. This worldwide tax system differs from most other countries, where only activity within the country's borders is taxed (territoriality).

U.S. corporations operating overseas there­fore face a unique combination of burdens not borne by their international competitors: taxes owed to the United States, taxes owed to the country where the operating activity takes place, and a complex tax system that attempts to reduce the resultant economic harm but involves an array of credits and definitions (primarily the Internal Revenue Code's Sub­part F).

One illustrative example is the taxation of royalty income earned overseas by U.S. compa­nies. Generally, U.S. taxes are deferred, or not immediately owed on profits earned overseas (a practice known as deferral) if the activity meets a stringent "active trade or business test" requiring active engagement by the U.S. corpo­ration in the actual development, creation, or production activities. Passive income (royal­ties, interest, dividends, and other investment income that does not meet this test) is thus excluded from the protections of deferral and subject to immediate U.S. taxation. This prac­tice is justified by the belief that mobile and liquid income earned overseas by U.S. com­panies is undertaken purely for tax avoidance reasons.

Whether or not that belief has any merit, a strange quirk in the system is that royalty income that meets this "active" test is none­theless subject to immediate U.S. taxation if there is involvement by a related party (an individual, corporation, partnership, estate, or trust that controls the company or is controlled by the company1). This limitation is redundant to the "active" test and sweeps legitimate over­seas business operations (those involving active income between related parties) into a prohi­bition not intended for them. These quirks should be remedied, but they only highlight the necessity of reforming our entire tax system into one that is competitive and compatible with the rest of the world.

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