Territorial Tax System

Territorial taxation is a system that excludes foreign earnings from a country’s domestic tax base. This is common throughout the world and is the opposite of worldwide taxation, where foreign earnings are included in the domestic tax base.

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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 US company with a subsidiary in the UK. That subsidiary paid the UK’s 25 percent corporate tax on its earned profits. The US parent company now decides to bring these profits back to the United States (also known as repatriation). Under a territorial tax system, the US parent company does not owe additional US corporate tax on these repatriated profits.

The United States’ territorial tax system—enacted as part of the 2017 Tax Cuts and Jobs Act (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.

Tax systems can also have territorial treatment for individual income. For example, an individual may work and earn money outside of their home country, and the home country would not tax that foreign-earned income.

The United States has a worldwide system for taxing individuals’ earnings though. So US citizens living and working abroad still have to file and may (in some circumstances) owe taxes to the US government on foreign earnings.

Territoriality and Base Erosion and Profit Shifting

Looking at rules throughout the developed world, it is not clear that there exists a “perfect” or pure territorial tax system. This is because the taxation of corporate profits is fundamentally challenging. Thus, countries need to make several trade-offs in designing their systems.

A territorial tax system basically must balance three competing goals:

1. Exempting foreign business activity from domestic taxation
2. Protecting the domestic tax base
3. Creating simple rules

To address these base erosion and profit shifting concerns, countries enact anti-tax avoidance rules. These can take various forms, including controlled foreign corporation rules, limitations on the deductibility of cross-border payments, and other general anti-avoidance rules.

The US has a regime known as Subpart F that acts as a controlled foreign corporation rule. While Subpart F has been in the tax code since 1962, Congress also enacted an additional set of anti-tax avoidance provisions in 2017, including the global intangible low-taxed income (GILTI) and

What Is a Worldwide Tax System?

Under a worldwide tax system, foreign-earned income is generally included in the business’ domestic tax base. Over the last three decades, most Organisation for Economic Co-operation and Development (OECD) countries have shifted from worldwide taxation toward territorial taxation. This shift reflects countries’ desires to reduce barriers to international capital flows and to increase the competitiveness of domestically headquartered multinational firms.

Further Reading:

https://taxfoundation.org/research/all/global/base-erosion-profit-shifting-pillar-two/

https://taxpolicycenter.org/briefing-book/what-territorial-tax-and-does-united-states-have-one-now

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