Lawmakers will undoubtedly make changing the way the United States taxes foreign profits of U.S. multinationals a priority of taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform. A territorial tax corporate system would be an improvement over our current worldwide tax systemA worldwide tax system for corporations, as opposed to a territorial tax system, includes foreign-earned income in the domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. , but requires careful thought about what sort of rules to enact to prevent base erosion and profit shifting by U.S. multinational corporations. Yet, if lawmakers want to make sure a territorial tax system eliminates the distortions of the current system, it will need to make sure base erosion rules do not overly burden real foreign business activities by U.S. multinationals.
Under the current “worldwide tax system,” foreign investments made by U.S.-based companies can be less profitable and less competitive relative to investments made by their foreign competitors. As a result, companies have an incentive to move their headquarters out of the United States. A territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. would eliminate the incentive to invert. Companies would be completely indifferent to the location of their headquarters because their foreign investments would only face the tax rate of the place in which they operate. U.S. companies would no longer need to invert to be on the same playing field as foreign companies.
Inversions would no longer be a challenge under an idealized territorial tax system, but such a change would introduce the potential for base erosion. Because companies would no longer face an additional tax on foreign profits that are repatriated to the parent company (that they currently face under a worldwide tax system), multinational corporations would have a greater incentive to avoid U.S. tax.
Base erosion under a territorial tax system can be addressed with different types of rules. A common way countries attempt to prevent base erosion is through what are called CFC (controlled foreign corporation) rules. CFC rules work by immediately taxing certain foreign income earned by resident corporations. The breadth of CFC rules varies immensely, but they typically attempt to target highly mobile “passive” income such as dividends, interest, royalties, etc., and income that has been taxed at a lower effective tax rate.
While the United States already has CFC rules, and while a lower statutory tax rate would somewhat reduce the incentive for companies to shift profits overseas, U.S. base erosion rules would still need to be strengthened as part of a reform.
However, lawmakers who want to see a territorial tax system that meaningfully improves the corporate tax code and eliminates the incentive to invert shouldn’t lose focus of the main goal of a territorial tax system: eliminating U.S. taxes on foreign business activity. To do this, anti-base erosion rules should try as best they can to exempt active foreign business activity. Put another way, base erosion rules should focus primarily on taxing passive or highly mobile foreign income which may represent profits that were actually earned in the United States.
The more that anti-base erosion rules apply to active income, the more that a territorial tax system is really just a toned-down worldwide tax system. Under broad anti-base erosion provisions, such as a broad minimum tax on all foreign earnings, companies would still face U.S. taxation on their active foreign profits. And companies would still have an incentive to shift their headquarters out of the United States to avoid the minimum tax.
This is why many countries with CFC rules seek to exempt foreign active income earned by their firms. I found that, in some countries, CFC rules subject all low-taxed foreign profits to taxation, whether active or passive. However, these countries use a number of active-business exemptions to limit the extent to which this happens. For example, when Estonian CFC rules apply, they subject all income—active and passive—to taxation. However, they exempt controlled foreign corporations from any taxation whatsoever as long as 50 percent of the CFCs’ income is related to real economic activity. In fact, nearly all OECD countries have some sort of active business activity exemption. Even the minimum tax that President Obama proposed during his presidency had a provision that sought to limit the taxation of active foreign profits by providing what was called an “allowance for corporate equity.”
Perfectly exempting active income and only taxing income that arises from profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. would be ideal under a territorial tax system, but comes with complexities. Countries that use active-business tests must analyze the type of business activities a CFC is performing, and that comes with complications and compliance costs. This is probably why some lawmakers may be drawn to a simpler across-the-board minimum tax on foreign profits. However, they should be cautious of that approach. Depending on its design, a minimum tax could further encourage companies to invert, which is counter to the goal of a territorial tax system.
Base erosion rules will be required as part of any move to a territorial tax system, but they must be balanced against the primary goal of a territorial tax system: limiting the U.S. corporate tax to the real domestic profits of corporations in the United States.
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