The Puzzling Policy of Foreign Tax Credits
May 31, 2016
This month, the Australia Institute released a report that argues persuasively that a substantial portion of Australia’s corporate income tax cuts will simply end up resulting in increased revenue for the U.S. Treasury. As the report explains:
Foreign companies have to pay tax in their place of residence and that complicates matters. Under the various foreign tax treaties with Australia, a tax paid on one jurisdiction can be used as an offset against tax payable in the home country. Hence US companies receive a tax credit for tax paid in Australia which they can apply against their US tax. That can mean the foreign investors themselves most likely obtain no benefit from any reduction in Australian company tax; it just increases the US tax.
Simply put, if you pay a dollar in taxes to Australia, you owe a dollar less in taxes to the IRS. If you reduce your Australian tax burden by a dollar, then you owe a dollar more in taxes to the IRS. It’s as if there’s an equal tradeoff between them, due to the foreign tax credit.
Credits for taxes paid are usually used in the context of a single system: for example, a European credit-invoice value-added tax (VAT). If a business buys from another business in a country like France, it gets a credit against the VAT for VAT already paid. This makes a fair amount of sense: VAT revenue for France from one source is just as good as VAT revenue for France from another source, so it should treat them as equals and let them offset each other at a one-to-one rate.
But there’s no reason this should be true internationally. The essential question for U.S. policymakers is this: is it in the U.S.’s best interests to have the U.S. Treasury treat U.S. revenues and Australian revenues as equal priorities?
This doesn't make a whole lot of sense, and this is because it's part of a larger system that doesn't make a whole lot of sense. Relatively unique to the U.S. is a system of "worldwide" taxation, in which U.S. corporations owe tax on their activities abroad.
Our worldwide system doesn't just impact the competitiveness of our multinationals; it allows other countries to define our tax base. Australia, when it changes its tax rate, defines our federal revenues, which is dubious policy from our perspective. It would be better to stop having the IRS concerned with what goes on abroad; this would best be done through a territorial or dividend exemption system. Under such a system, we would no longer concern ourselves with the tax regimes of foreigners. Instead, we would allow our corporations to operate freely in other countries under whatever tax systems those countries impose. Then, to the exent that this makes money for U.S. shareholders, the income would be taxed at the shareholder level.