Over the past 30 years, many countries have moved away from “worldwide” 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. systems that tax their domestic corporations’ worldwide profits. Instead, many countries have what is called a “territorial” tax system. 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. generally allows corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s to deduct or exclude the majority of dividends received from their foreign operations. Currently, 91 countries have a territorial tax system of some kind.
As stated above, a worldwide corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. system adds income earned by the foreign operations of a corporation to the taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. of the parent. This is the system that the United States currently uses.
Suppose a U.S. corporation opens a subsidiary in the United Kingdom. The subsidiary in the United Kingdom makes $10,000 a year after labor and material costs. In the United Kingdom, corporate income is subject to a 20 percent tax. As such, the subsidiary pays the British government approximately $2,000. Then, when the subsidiary in the United Kingdom pays $10,000 in dividends to the U.S. parent corporation, those dividends are subject to the U.S. tax of 35%, or $3,500.
To prevent double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. , the United States provides a foreign tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. to the corporation for taxes paid in the United Kingdom. In our example, the U.S. corporation would owe $3,500 in U.S. taxes on the $10,000 in dividends that the subsidiary in the United Kingdom remitted. However, the corporation would be able to credit the $2,000 in taxes it already paid to the British government. Thus, the U.S. corporation would pay $1,500 to the IRS, $3,500 minus $2,000.
If the United States had a territorial tax system, the result would have been different. Specifically, the U.S. corporation would not have to pay any additional tax to the IRS on the income earned in the United Kingdom.
The difference between a territorial and a 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. becomes important when, for example, a French corporation is competing with an American corporation in the United Kingdom. The American corporation would have a higher tax burden despite earning income from the same source as the French corporation. Therefore, American multinationals are put at a disadvantage over corporations domiciled in other countries due to cost differences.
However, this competitiveness concern is partially mitigated by one other important aspect of the U.S.’s worldwide system: deferral. The United States, and many other countries with a worldwide tax systems, only taxes foreign income when it is remitted to the parent corporation. However, this same policy that quells competitiveness concerns creates another issue: the lockout effect — because U.S. companies (and companies based in other countries with worldwide tax systems) can defer the taxation of foreign earnings by keeping them overseas.
Many countries don’t deal with this issue anymore because of their move to a territorial tax system.
Of course, the distinction we make here between territorial and worldwide in the map is a simplified version of what is happening around the world. The way we distinguish between the systems is simply their treatment of dividends received from foreign controlled corporations. Countries’ tax systems have many other characteristics. Many other sources of foreign income may still be taxed; some countries tax worldwide passive income, and some countries limit their territorial tax system to dividends received from subsidiaries in specific countries.Share