The Top Ten Reasons Territorial Taxing of Foreign Earnings Makes Sense

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The debate in Washington continues over how U.S. companies should be taxed on the profits earned overseas, but everyone agrees the U.S. must become more competitive in the new global economy.

Currently, business income is taxed at the U.S. rate no matter where it is earned: at home or overseas. However, companies can defer paying U.S. tax on current foreign income until it is brought back to America.

Key Point: So that companies do not have to pay taxes twice on their income, once to the host country as well as to the U.S., the tax code provides a credit on companies’ U.S. tax return for foreign taxes paid. Com­panies then have two choices for the net profits: bring them home to America or reinvest them in foreign operations.

If a company brings the profits back home, they must pay the difference between the amount of tax paid to the foreign govern­ment and the amount owed under the U.S. rate of 35%. But many companies choose the more attractive route of reinvesting those profits in foreign operations to defer pay­ing the additional U.S. tax indefinitely.

The current system of taxation encourages companies to keep their profits offshore and avoid paying U.S. taxes on that income. This practice recognizes that income should not be taxed until it is real­ized (or repatriated), and puts U.S. companies on a level playing field with foreign competi­tors who don’t operate under a worldwide tax system. Some say our current international tax code should move to a territo­rial system like that of other capitalist nations, under which almost all foreign income of U.S. multinational companies would be taxed where it is earned and could be brought back to the United States without incurring additional tax. A territorial system of taxation would end the residual U.S. taxation of active business income earned outside the U.S.

The territorial taxation proposal was released last Fall by the House Ways and Means Committee and assumes the top corporate rate will be lowered to 25% from the current rate of 35% and would be revenue neutral.

Going forward, Lawmakers can maintain the current deferral system and international tax rules for taxing the foreign earnings of U.S. multinationals, or:

  • Eliminate deferral and move toward a pure worldwide system of taxation
  • Move toward a territorial system and tax only those profits earned within the U.S. borders

The Tax Foundation lists these as the top 10 reasons why our current international tax rules should be replaced with a territorial system that exempts most foreign profits from U.S. tax:

1. The U.S. system must be aligned with our global trading partners model of lower tax rates and exemption of foreign earnings.

2. The Experiences of Japan and Great Britain are lessons for the U.S. A worldwide system combined with a high corporate tax rate is a disincentive to repatriating profits. High tax rates force companies with large global sales to relocate to lower taxed countries.

3. The premise of the worldwide tax system – capital export neutrality (CEN) – is obsolete when subsidiaries have access to global capital markets and can self-fund their expansion with retained earnings.

4. The worldwide tax system violates the benefit principle of taxation. Countries have the right to tax income generated within their borders to pay for the benefits that corporations receive while operating there. Why tax companies on profit earned in another country for which they have already paid taxes?

5. The U.S. maintains a territorial tax system for foreign-owned companies but a worldwide system for U.S. companies. Mov­ing to a full territorial system will level the playing field.

6. The compliance cost of the current system is excessively high relative to companies’ foreign activities and the revenues raised from taxing foreign-source income.

7. Our current system traps capital abroad – the “lockout” effect. The willingness of multinational firms to bring home foreign profits is highly sensitive to the level of repatriation tax rates.  This explains the high level of excess cash held by foreign subsidiaries of US companies and the unwillingness of US companies  to repatriate such cash to the US.

8. Our high corporate tax rate and worldwide system makes it cheaper for companies to take on debt rather than use their own profits to fund their growth. This can also further inhibit profit repatriation because companies with US debt levels and valuable foreign operations may experience a reduced capacity to take a foreign tax credit for profits repatriated from foreign subsidiaries.

9. The current system dissuades global companies from headquartering in the U.S. because they do not want to expose their non-U.S. profits to our high rate and worldwide tax system.

10. Eliminating deferral nearly killed the U.S. shipping industry.

All of the above reasons have merit, but of course need to be assessed in conjunction with the ability of US companies to easily shift profits overseas.  One discussion cannot occur without the other.

Experts don’t expect much progress on the issue of corporate tax reform before the 2012 elections. Should you have questions regarding this issue or need information regarding international tax planning and compliance, please contact Mark Chaves, CPA, PA, Partner-in-Charge of International Tax at Daszkal Bolton, at 561-367-1040, or [email protected].

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