Policy Documents

Moving to a Territorial Income Tax: Options and Challenges

Jane G. Gravelle –
July 25, 2012

Among potential tax reforms under discussion by Congress is revising the tax treatment offoreign source income of U.S. multinational corporations. Some business leaders have beenurging a movement toward a territorial tax, which would eliminate some U.S. income taxes onactive foreign source income. Under a territorial tax, only the country where the income is earnedimposes a tax. Territorial proposals include the Grubert-Mutti proposal (included in PresidentBush’s Advisory Panel on Tax Reform proposal in 2005) and, more recently, a draft Ways andMeans Committee proposal and a Senate bill, S. 2091. The Fiscal Commission also proposed aterritorial tax. Proposals have, however, also been made to increase the taxation of foreign sourceincome, including S. 727, and proposals by President Obama.

Although the United States has a worldwide system that includes foreign earnings in U.S. taxableincome, two provisions cause the current system to resemble a territorial tax in that very little taxis collected. Deferral delays paying taxes until income is repatriated (paid as a dividend by theforeign subsidiary to its U.S. parent). When income is repatriated, credits for foreign taxes paidoffset the U.S. tax due. Under cross-crediting, unused foreign tax credits from high tax countriesor on highly taxed income can be used to offset U.S. tax on income in low tax countries.

Some proponents of a territorial tax urge such a system on the grounds that the current systemdiscourages repatriations. Economic evidence suggests that effect is small, in part because innormal circumstances a large share of income is retained for permanent reinvestment. Amountsheld abroad may have increased, however, as firms lobbied for another repatriation holiday(similar to that adopted in 2004) that allowed firms to exempt most dividends from income on aone-time basis. Opponents are concerned about encouraging investment abroad. A territorial tax isgenerally not viewed as efficient because it favors foreign investment, but that increased outflowof investment is likely to have a small effect relative to the U.S. economy. Artificial shifting ofprofits into tax havens or low tax countries is a current problem that could be worsened undersome territorial tax designs, and proposals have included measures to address this problem.

Proposals also address the transitional issue of the treatment of the existing stock of unrepatriatedearnings. The Ways and Means proposal would tax this stock of earnings, but at a lower rate, anduse the revenues to offset losses from other parts of the plan, which would lead to a long-runrevenue loss. S. 2091 has a similar approach. The Grubert-Mutti proposal does not have a specifictransitional tax, but would raise revenue largely due to its disallowance of parent overheadexpenses aimed at reducing profit shifting. The other two proposals also contain provisions toaddress profit shifting.

In addition there are complicated issues in the design of a territorial tax, such as how to treatbranches and dividends of firms in which the corporation is only partially owned. A number ofissues arise from the ending of foreign tax credits, with perhaps the most significant one being theincreased tax on royalties, which are currently subject to tax, have low or no foreign taxes, andwould lose the shield of excess credits.

The final section of the report briefly discusses some alternative options, including those in S.727 and in the Administration proposals. It also discusses hybrid approaches that combineterritorial and worldwide systems in a more efficient way, including eliminating the disincentiveto repatriate. One such approach is a minimum tax on foreign source income, which is proposedby the President in the context of current rules, but could be combined with a territorial system.