In 1918, the United States enacted a foreign tax credit (FTC) system for taxing foreign-source business income earned by multinational corporations (MNCs). (1) This system, known as “worldwide” taxation is said to implement “capital export neutrality” by neutralizing a citizen’s decision between investing domestically or abroad. (2) About half of the Organization for Economic Co-operation (OECD) countries have adopted a similar approach. (3) However, as foreign trade agreements and the complexity of U.S. tax treatment continue to increase, a “territorial” taxation system, as implemented by the other half of OECD countries, might be worth considering in the United States. (4)
This article will 1) define some of the underlying principles behind international tax policies, 2) suggest a proposal for a tax-exemption system, 3) explain how the proposal solves problems under the current system, and finally 4) attempt to rationalize potential criticisms surrounding an exemption system.
The existing U.S. foreign tax credit rules are extraordinary complex and require American companies doing business abroad to spend large and disproportionate amounts in compliance. (5) One study estimated that “nearly 40 percent of the income tax compliance costs of U.S. multinationals is attributable to the taxation of foreign-source income, even though foreign operations account for only about 20 percent of these companies’ economic activity.” (6) In addition, “recent economic research suggests that moving to an exemption system might increase revenue to the U.S. Treasury by over $9 billion annually.” (7) For these reasons, economists have suggested that the United States adopt a territorial system similar to trading partners like Germany, Canada, and the Netherlands. (8) Territorial systems allow for a tax-exemption instead of a tax credit, and are said to implement “capital import neutrality” by subjecting all business activity in a specific country to the same overall level of taxation despite citizenship. (9) Regardless of the tax regime, the primary goal is to avoid double taxation without encouraging U.S. taxpayers to shift operations, assets, or earnings abroad. (10) However, to understand these concepts better, one must be familiar with the underlying principles behind international tax policy.
III. International Tax Policy Principles
Under tax rules, the “source” country refers to the location where income is earned typically by an investor, who resides in the “resident” country. (11) Therefore, “foreign-source business income” for this discussion refers to the income derived in foreign-source countries by American companies. While nations recognize that both the country of residence and the country of source are entitled to tax income, the country of source is said to have the primary right to tax active business income. (12) However, complications occur when both the source and the resident country simultaneously exercise their rights to tax, resulting in an injustice to taxpayers who end up being taxed twice on the same income. (13) The current U.S. worldwide system mitigates the effects of double taxation by allowing American firms to claim tax credits on foreign-source income only in the case that it is taxed in excess of U.S. domestic taxes. (14)
This article proposes that the United States replace the current worldwide system with a territorial system by exempting active foreign-source business income along with dividends from active business income from taxation. Although the Internal Revenue Code and Treasury Regulations do not provide a comprehensive definition for “active business income,” it generally refers to income derived in the normal course of trade or business. (15) Alternatively, income that does not fall under this definition is usually referred to as “passive income.” Under the new system, passive income and U.S. source business income will not receive tax-exemptions, unless provided for under de minimus rules. (16) Passive income cannot receive exemption because unlike active business income, it is highly mobile, lacks any nexus to business activity, and is likely to escape taxation by any country. (17) Finally, to ensure the success of such a system, current anti-abuse tax rules and some forms of tax credits must remain in effect as they exist today.
V. How it Solves Problems Under the U.S. System
The current U.S. worldwide system can be costly, complicated, and inefficient. As mentioned earlier, companies are spending disproportionate amounts to comply with the current tax regime. (18) Part of the reason is because the current U.S. system disadvantages a U.S. MNC’s ability to raise capital and causes inefficiency. The worldwide tax burden decreases the after-tax returns of foreign investing firms, resulting in higher costs of capital. (19) In turn, these costs cause U.S. MNCs in foreign jurisdictions to become less productive and undercapitalized. (20) This places U.S. MNCs at a disadvantage in competition with foreign MNC counterparts (most of which exempt taxation from foreign-source income) when competing in the same jurisdictions. (21) This may also discourage potentially profitable business or immature U.S. businesses from capitalizing fully in new foreign ventures or acquiring other foreign MNCs. (22) The current system therefore creates inefficiency by distorting allocation of capital between foreign MNCs in relation to US MNCs with higher tax burdens. (23) Under an exemption system, however, financial constraints on investment will be relaxed, allowing U.S. MNCs to free up capital, pay higher wages through greater productivity, and essentially increase the productivity of domestic firms through positive spillovers. (24) It is estimated that U.S. MNCs will be able to positively contribute to economic welfare by increasing the U.S. Treasury by billions annually. (25)
Additionally, foreign tax credit systems are very complicated and costly because they require extensive research and increased regulation to prevent tax abuses and evasions. One of the abuses that the current system tries to prevent is “cross-crediting. (26) Cross-crediting occurs when an activity generates excess foreign tax credits, which are then used to offset or minimize U.S. taxes on other items of income. (27) To alleviate this trend, the U.S. government has implemented a complicated basket system to reduce cross-crediting by placing different incomes in separate “baskets.” (28) If the United States were to switch to an exemption system, the basket system could essentially be eliminated. (29) This is not to say that all anti-abuse rules could be eliminated, however, under an exemption system.
Finally the current system is inefficient in that it creates ownership distortions by encouraging U.S. MNCs to place assets abroad. The current tax system is based on residence which places emphasis on seemingly fictional differences. (30) For example, income earned by French residents in France is not subjected to a U.S. tax, alternatively, if the income is earned by a U.S. MNC, the United States will tax French source income allocable to French shareholders of the U.S. corporation. (31) Consequently, there is a large incentive to move parent corporations by locating headquarters out of the United States. Not only are American firms spending significant amounts of resources to engage in tax planning, but also the U.S. Treasury in an attempt to curb such efforts. (32) Under the proposed exemption system, however, residence would no longer be a controlling factor, and costs associated with these problems would largely disappear. (33)
VI. Potential Criticisms
A country engaging in an exemption system accepts the fact that investors will experience different taxes depending on the tax rates of the countries in which they invest or do business. (34) A potential criticism is that this leads to locational distortions by creating an incentive for owners to invest in the lowest tax jurisdictions abroad to maximize after-tax returns. This arguably results in investment leaving the United States. (35) However, opponents overlook the fact that the current system creates similar incentives. For example, the U.S. tax treatment does not tax active foreign income until it is repatriated back to the United States, generally in the form of dividends. (36) (As mentioned earlier, dividends would be exempt and therefore, no deferral regimes would exist under the new proposal.) For this reason, U.S. held foreign subsidiaries will likely retain this income abroad until the amount reaches equilibrium. (37) In other words, the amount will be retained and most likely be reinvested as foreign capital or assets, thereby avoiding taxation. Consequently, the result has the same effect as if the income from the capital investment were exempt from tax. (38)
Furthermore, others might argue that replacing the current U.S. system with an exemption system would be more complicated. A National Foreign Trade Council (NFTC) report concluded that “on balance, legislative efforts to improve current international tax rules are better spent on reform of our current deferral and foreign tax credit system.” (39) One study predicted that it would cost the United States an additional $5.2 billion a year to implement such a change. (40) However, many economics contest this statistic and believe that the United States will ultimately see an increase in revenue inflows in the long run. (41) Although there would seemingly be additional complication involved with moving to an exemption system, “such a move does provide an opportunity to reconsider a variety of issues that might simplify taxation of international business incomes.” (42)
This article proposes that the United States replace the current worldwide system with a territorial system by exempting active foreign-source business income along with dividends from active business income from taxation. Under the new system, passive income and U.S. source business income will not receive tax-exemptions, unless provided for under de minimus rules. (43) Finally, many of the current anti-abuse tax rules and some forms of tax credits will exist as they do today.
One must understand that there are still potential abuses and criticisms with the proposed system however, no system is without fault. Furthermore, changing to an exemption system would allow American companies to be more in line with foreign business partners, and clearly solve the more complicated, costly, and inefficient problems that exist under the current system.
(1) Michael J. Graetz & Paul W. Oosterhuis, Structuring an Exemption System for Foreign Income of U.S. Corporations, 54 Nat’l Tax J. 771, 772 (2001). The Organization for Economic Co-operation and Development (OECD) is an organization consisting of thirty member countries, which attempts to “seek answers to common problems and work to co-ordinate domestic and international policies to help members and non-members deal with an increasingly globalized world.” OECD Homepage, available at http:www.oecd.org.
(2) Id. at 771.
(3) Id. at 772.
(6) Marsha Blumenthal & Joel B. Slemrod, The Compliance Cost of Taxing Foreign-Source Income: Its Magnitude, Determinants, and Policy Implications, 2 Int’l. Tax & Pub. Fin. 37.
(7) Harry Grubert, Enacting Dividend Exemption and Tax Revenue, 54 Nat’l Tax J. 811, 816-817 (2001).
(8) Rosanne Altshuler & Harry Grubert, Where Will They Go if We Go Territorial? Dividend Exemption and the Location Decisions of U.S. Multinational Corporations, 54 Nat’l Tax J. 787, 787 (2001).
(9) Michael J. Graetz, The David R. Tillinghast Lecture Taxing International Income; Inadequate Principles, Outdated Concepts, and Unsatisfactory Policies, 54 Tax L. Rev. 261, 271 (2000).
(10) Graetz & Oosterhuis, supra note 1, at 772.
(11) Michael J. Graetz, Foundations of International Income Taxation 5 (2003).
(12) Graetz & Oosterhuis, supra note 1, at 772.
(13) Graetz supra note 11, at 5.
(14) Mihir A. Desai, James R. Hines, Jr. & Mark F. Veblen Corporate Inversions: Stanley Works and the Lure of Tax Havens (Harvard Business School, 2002).
(15) Graetz supra note 11, at 267. “’Trade or business’ is any considerable, continuous, and regular activity engaged in for profit.”
(16) Graetz & Oosterhuis, supra note 1, at 775. For simplification, a de minimus rule may be necessary to ignore small amounts of passive income by companies that might lead to an unacceptable level of tax planning.
(18) Id. at 772.
(19) Terrence R. Chorvat, Ending the Taxation of Foreign Business Income, 42 Ariz. L. Rev. 835, 846 (2000). Assume that an American firm earning $100 of foreign income faces a U.S. tax rate of 35%, and is therefore subject to a foreign tax credit limit of $35. If the firm pays more than $35 in taxes, for example, $70 in foreign taxes, then it would be permitted to claim a tax credit upon repatriation to the U.S., but no more than the $35 foreign tax credit limit. Alternatively, if the firm pays foreign income taxes of less than $35, then the firm would have to pay additional taxes to reach the $35 tax limit imposed upon repatriation to the United States. Therefore, if an American firm is located in a foreign jurisdiction with a tax rate of 20%, it will still be effectively paying $35 after it is taxed under the worldwide system, instead of $20 if the foreign-source income had been exempt in the U.S.
(22) Id. at 847.
(23) Id. at 846.
(24) Michal P. Deveruex, The Impact of Taxation on the Location of Capital, Firms and Profit; A survey of Empirical Evidence (2006).
(25) Grubert, supra note 7, at 816-817.
(26) Chorvat, supra note 19, at 851.
(30) Id. at 852.
(33) Id. at 853.
(34) Paul R. McDaniel, The U.S. Tax Treatment of Income Earned in Developing Countries, 35 George Wash. Int’l L. Rev. 265, 272 (2003).
(35) Chorvat, supra note 19, at 842.
(36) Id. at 843.
(38) McDaniel, supra note 34, at 270.
(39) Nat’l Foreign Trade Council, Inc., The NFTC’s Report on Territorial Taxation, 27 Tax Notes Int’l 687, 689 (2002).
(41) Grubert, supra note 7, at 816-817.
(42) Graetz & Oosterhuis, supra note 1, at 784.
(43) Id. at 775. For simplification, a de minimus rule may be necessary to ignore small amounts of passive income by companies that might lead to an unacceptable level of tax planning.