A 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.
Worldwide Taxation in the United States
Prior to the 2017 TCJA, the United States operated a worldwide tax system—also known as a residence-based tax system—under which U.S. corporations were required to pay U.S. corporate income taxes on all earnings worldwide, with a credit for foreign corporate taxes paid.
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. Under the previous worldwide tax system, the U.S. parent company would effectively owe an additional 16 percent tax on those earnings—the difference between the UK’s 19 percent and the old 35 percent U.S. corporate tax rate—if they were brought back to the United States.
Under the new territorial tax system, however, the U.S. parent company does not owe additional U.S. corporate tax on these repatriated profits.
How Worldwide Taxation Affects Repatriation
The previous worldwide system—combined with what was a relatively high U.S. corporate income tax rate of 35 percent—heavily discouraged the transfer of earnings back into the United States, otherwise known as “repatriation.” This is because multinational businesses could defer their U.S. tax liability on foreign-earned profits by reinvesting or holding them overseas instead of bringing them back to the United States.
The New Territorial Tax System in the United States
The new territorial tax system—enacted as part of the 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.
International Trend Towards Territorial Taxation
Over the last three decades, most OECD countries have shifted from worldwide taxation towards territorial taxation. The goal of many countries has been to reduce barriers to international capital flows and to increase the competitiveness of domestically headquartered multinational firms. Today, only four OECD countries—Chile, Israel, Korea, and Mexico—operate a fully worldwide tax system for corporations.
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