<div>Territorial Taxation: Choosing Among Imperfect Options By EricToderDecember 2017   <div class="indented"> Both territorial and worldwide systems for taxing income of multinational companies are difficult to implement because the concepts of income source and corporate residence on which the systems are based have become less economically meaningful. Recent legislation enacted by the House and Senate would move the United States toward a territorial system for taxing US multinational corporations by eliminating taxation of dividends that foreign affiliates repatriate to their US parent companies. To protect the domestic corporate tax base, the bills would intro- duce a new minimum tax on foreign-source intangible profits of US multinational companies and include measures to curb income stripping by foreign-based multinationals from their US- owned subsidiaries. They would also impose a one-time transition tax, paid overtime, on the accumulated foreign earnings of US companies. By eliminating the repatriation tax, the bills would remove a tax distortion that has led US companies to accumulate more than $ 2 .6 tril- lion of past profits in their foreign affiliates, but would retain incentives for US companies to shift investment and reported profits overseas and would continue to place some US compa- nies at a competitive disadvantage compared with foreign-based companies that pay no home- country taxon their foreign-source income. Compared with current law, the new corporate income tax rate of 20 percent would reduce all these remaining economic distortions. </div>       One major feature of the tax bills moving throughthat US-resident multinational eorporations Congress at the end of 2017, as well as the proposalsreeeive from their foreign affiliates. In eontrast, of all major Republiean presidential eandidates inunder current law these dividends or repatriated recent years, is a provision that would create aprofits are taxable in the United States, but with a territorial tax system for the United States. Pro-credit for the underlying foreign income taxes ponents have come to define territorial taxationpaid on the profits that produced the dividends.^ as a system that exempts from tax the dividends         ' Late Friday night, December 1, before the final vote, the Senate added a provision restoring the corporate alternative minimum tax (AMT), which earlier versions of both House and Senate bills would have repealed. Com m entators have         AMERICAN ENTERPRISE INSTITUTE Doc 2017-99227 Page: 1 of 8   Overview Both territorial and worldwide systems for taxing income of multinational companies are diffieult to implement beeause the coneepts of income souree and corporate residenee on which the sys- tems are based have become less economically meaningful.                                                             <div class="indented"> <div class="indented"> Worldwide Taxes. Under a worldwide system, eoun- tries would still tax all ineome earned within their borders, but also tax the foreign-souree profits of their resident companies. To prevent double taxa- tion, they would allow tax credits to offset the for- eign income taxes their companies pay. Usually, countries attempt to limit these eredits to the tax rate they would impose on domestic corporate profits. </div> </div>         observed that restoring the AMT could (inadvertently) nullify the international reforms in the legislation. For this pa- per, it is assumed the eorporate AMT will be repealed or modified so that the international reforms remain in plaee.           AMERICAN ENTERPRISE INSTITUTE       Table 1. USTax Rules Under Woridwide and Foreign Taxes   Residence/SourceUS-Source IncomeForeign-Source Income US-Resident CorporationsTaxation at US corporateNo US taxation under a territorial sys- <div class="indented"> <div class="indented"> rate under both systemstem; taxation at US rate with a credit </div> </div> <div class="indented"> <div class="indented"> for foreign income tax up to the US rate under a worldwide system </div> </div> Foreign-Resident CorporationsTaxation at US corporateNo US taxation under either system <div class="indented"> <div class="indented"> rate under both systems </div> </div> Source: Author’s analysis.                                                                                                           AMERICAN ENTERPRISE INSTITUTE         <table> <tbody> <tr> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td> </td> </tr> </tbody> </table>                                                                                                     Implementation Issues In practice, pure territorial and pure worldwide taxes have become extremely diffieult to imple- ment because both the source of corporate in- come and the residence of corporations are no longer meaningful economic concepts.                                         AMERICAN ENTERPRISE INSTITUTE   <div class="indented"> <div class="indented"> employment, sales, share ownership, and even re- search and some eentral management functions in multiple jurisdictions. </div> </div> <div class="indented"> <div class="indented"> Worldwide taxation, therefore, would greatly increase incentives for corporate residence to shift away from the United States. Inversion transae- tions are only one way for residenee to shift. Other mechanisms include mergers between equal-sized firms, buyouts of US companies or divisions of US companies by foreign purchasers, and contracting out production by US companies to locally resi- dent eorporations to take advantage of lower for- eign corporate ineome tax rates. </div> </div>   <div class="indented"> <div class="indented"> How Current Legislation Addresses Issues in Moving to a Territorial Tax </div> </div>                       <div class="indented"> <div class="indented"> Preventing Base Erosion. The tax base of the US and other leading eeonomies is vulnerable to ero- sion from several sourees. </div> </div>                                       AMERICAN ENTERPRISE INSTITUTE       taxnote DOCUMENT SERVICE Doc 2017-99227 Page: 6 of 8         the affiliate's adjusted basis in depreciable tangi- ble property, while the Senate bill defines them as returns in excess of a 10 percent return on tangi- ble property. Both bills would allow foreign tax credits to offset only 80 percent of foreign income taxes on those high returns and would not allow firms to use the credits to offset tax liability in prior or future years. The House bill would also not allow firms to use the credits to offset US taxes on other foreign-source income. The minimum tax proposals are aimed at intan- gible profits: the returns from patents, trademarks, brand-name reputation, and other sources of firm value unrelated to tangible capital assets. The deductions of a portion of profits in the Senate and House bills are meant to exempt "normal" returns to tangible investment from the tax. The proposals are modeled on a proposal by econo- mists Harry Grubert and Rosanne Altshuler (2013) to impose a minimum tax at half the corporate rate on accrued foreign-source income, while ex- empting normal returns by allowing firms to claim an immediate deduction for all foreign investments. Grubert and Altshuler propose exempting normal returns for two reasons. First, the location of tan- gible capital is not as responsive to tax rate differ- entials as intangible capital because the former involves changing real investments instead of just financial structures. Second, US multinationals could more readily avoid a US residual tax on tan- gible profits by contracting out production to a foreign-resident company, while they are not likely to surrender ownership of their intangible assets. Replacing full taxation of intangible profits on repatriation with a minimum tax as the profits accrue may be a tax increase or decrease, depend- ing on the value of deferral. If firms repatriated profits annually, it would be a big decrease; if profits were never repatriated, it would be a big tax increase. The Joint Committee on Taxation (US Congress 2017) estimates that, for the Senate bill, revenue from the minimum tax on intangible profits in 2027 (when the rate is 12.5 percent) would replace almost 90 percent of the revenue loss in that year from repealing the repatriation tax. Firms would also benefit because the tax sys- tem would no longer interfere with the decision of whether to repatriate accrued foreign profits or reinvest them overseas. To further reduce the incentives for firms to shift reported profits to low-tax jurisdictions, the Senate bill would apply the same preferential rate (12.5 percent after 2025) to intangible profits reported to the United States that support export sales. US firms using their intangible assets for foreign sales would not need to move their intan- gible assets to foreign affiliates to benefit from the preferential tax rate. While this provision would reduce income shifting, it is estimated to lose additional revenue. The lost revenue on intangible profits already earned in the United States would exceed the additional taxes from shifting profits back to the United States. And expanding the preference the US tax law already provides to firms with intangible assets because their development is expensed and can sometime qualify for research credits would place US firms with tangible assets at a relative disadvantage. Finally, because the new tax benefit would apply to only intangibles used to support export sales, it might be subject to challenge from the World Trade Organization as an export subsidy. The estimated revenue loss in combination with the reduced efficiency losses from eliminat- ing the repatriation tax suggests that substituting a minimum tax for the repatriation tax may mod- estly increase the incentives for US multination- als to invest and report profits overseas instead of at home. In contrast, reducing the corporate rate to 20 percent would reduce that incentive because at the lower statutory rate all differences in tax treatment among investments matter less. Preventing Income Shifting by Foreign-Based Corpo- rations. The other source of base erosion is the shifting of profits outside the United States by foreign-resident companies with US affiliates. Reducing the corporate tax rate to 20 percent would increase the incentive for these companies to invest and report profits in the United States. The House and Senate bills contain additional provisions to prevent profit shifting by these firms. Those provisions reduce the incentive for foreign-based firms to invest in the United States by increasing the effective tax rate on their US profits, but they limit the shifting of those reported           AMERICAN ENTERPRISE INSTITUTE6   <div class="indented"> <div class="indented"> cause the proposals deny deduetions for eosts in- curred by purehases from foreign entities, they may raise issues of compliance with US obliga- tions under the World Trade Organization. </div> </div>                                                                                       <div class="indented"> <div class="indented"> Conclusions </div> </div>             AMERICAN ENTERPRISE INSTITUTE       About the Author Eric Toder is an institute fellow at the Urban Institute and codirector of the Urban-Brookings Tax Policy Center. The views in this paper are those of the author and do not represent the views of the Urban Insti- tute, its board, or its funders.     References Grubcrt, Harry, andRosannc Altshuler. 2013. “Fixing the System: An Analysis of Alternative Proposals for the Reform of Interna- tional Tax.” National Tax Journal 66, no. 3 (September): 671-712<a href="http://www.ntanet.org/NTJ/66/3/ntj-v66n03p671-712-fixing-system-reform-international-tax.html">. http://www.ntanet.org/NTJ/66/3/ntj-v66nO3p67i-7i2-fixmg-</a> <a href="http://www.ntanet.org/NTJ/66/3/ntj-v66n03p671-712-fixing-system-reform-international-tax.html">systcm-rcform-intcrnationa1-tax.html.</a> US Congress. Joint Committee on Taxation. 2017. “Estimated Revenue Effeets of the Chairman’s Modification to the Chairman’s Mark of the ‘Tax Cuts and Jobs Act,’ Scheduled for Markup by the Committee on Finance on November 15,2017.”JCX-57-17. November 15<a href="https://www.jct.gov/publications.html?func=showdown&amp;amp;id=5038">. https://\v\vw.jct.gov/publications.html?func=showdown&amp;id=5038.</a>             Arthur C. Brooks, President; Miehael R, Strain, Director of Eeonomic Policy Studies; Stan Veuger, Editor, AEI Economic Perspectives AEI Economic Perspectives is a publication of the American Enterprise Institute (AEI), a nonpartisan, not-for-profit, 501(c)(3) educational organization. The views expressed in AEI publications are those of the authors. AEI does not take institutional positions on any issues. © 2017 by the Ameriean Enterprise Institute. All rights reserved. For more inform ation on AEI Economic Perspectives, please visit <a href="http://www.aei.org/feature/aei-economic-perspectives/">http://www.aei.org/feature/aei-economic-perspectives/.</a>         AMERICAN ENTERPRISE INSTITUTE  </div>

AEI Report Examines Territorial Tax System Options

AEI Report Examines Territorial Tax System Options

American Enterprise Institute

In a December report, Eric Toder of the American Enterprise Institute reviewed options for a territorial system of taxation, implementation issues for such a system, and how current tax reform legislation would handle moving to a new territorial tax system.

In a December report, Eric Toder of the American Enterprise Institute reviewed options for a territorial system of taxation, implementation issues for such a system, and how current tax reform legislation would handle moving to a new territorial tax system.