Territorial Tax System

What is a Territorial Tax System?

A 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.

How Does a Territorial Tax System Work?

Countries enact territorial tax systems—also known as source-based tax systems—through so-called “participation exemptions.” These allow multinational businesses to exclude or deduct foreign-earned income from their domestic tax base, ensuring that such profits are only taxed in the foreign country in which they were earned.

For example, imagine a U.S. company with a subsidiary in the UK. That subsidiary paid the UK’s 19 percent corporate tax on its earned profits. The U.S. parent company now decides to repatriate these profits back to the United States. Under a territorial tax system, the U.S. parent company does not owe additional U.S. corporate tax on these repatriated profits.

Under the previous worldwide tax system, however, the U.S. parent company would have owed an additional 16 percent tax—the difference between the UK’s 19 percent and the old 35 percent U.S. corporate tax rate—on those repatriated earnings. This old system—worldwide taxation combined with a high corporate income tax rate—discouraged companies from repatriating their earnings, building up a large amount of earnings overseas and deferring U.S. tax liability.

The United States’ territorial tax system—enacted as part of the 2017 TCJA—generally excludes foreign-earned income from domestic taxation. However, certain types of income, such as foreign-earned capital gains and passive income, are not excluded, making the tax system only partially territorial.

Territoriality and Base Erosion and Profit Shifting

A common concern with shifting to a territorial tax system is base erosion and profit shifting (BEPS). Because companies no longer face an additional tax on foreign-earned profits, there is an incentive to shift domestic income to foreign subsidiaries located in low-tax jurisdictions to minimize worldwide tax liability.

To address these base erosion and profit-shifting concerns, the TCJA also enacted a new set of anti-tax avoidance provisions, such as the Global Intangible Low-Taxed Income (GILTI) and Base Erosion Anti-Abuse Tax (BEAT).

What Is a Worldwide Tax System?

Under a worldwide tax system, foreign-earned income is generally included in the business’ domestic tax base. You can find a more detailed explanation here.

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